Exchange rate flexibility, target zones, and policy coordination

Abstract

At its meeting in April 1986, the Interim Committee asked the [Fund's] Executive Board to consider further whether there are any modifications in the exchange rate that could contribute to enhancing exchange rate stability and the mutual consistency of economic policies without sacrificing the essential flexibility of the system (Interim Committee, 1986, para 5). This was interpreted by a part of the press as an official rejection of target zones, which was odd inasmuch as the target zone proposal can be regarded as a technique to limit misalignments and enhance policy consistency while retaining the very real benefits that exchange rate flexibility can bring. The present paper seeks to explain why I regard this intermediate regime between fixed and floating exchange rates as offering the most attractive combination of the features of the two systems. Section 2 of the paper explains briefly what I understand by the target zone proposal. Section 3 explains how the four dimensions of flexibility built into the proposal could satisfy all the real social functions that floating can further. Section 4 argues that the proposal could also help both to limit misalignments and to secure policy consistency. Section 5 explores the relation of the target zone approach to proposals for objective indicators.