Narrow Target Zones within Broad Zones: The Exchange Rate Solution with Limited Gunpowder

Abstract

The Central Banks around the world are commonly responsible for their exchange rate policies. During the 1990s it has been clear that the controllability of the exchange rates by the central banks' interventions is limited (McKinnon, 1993). When the underlying monetary reserves are bounded, which in practice is the case, a target zone can never be credibly defended at the official borders of an announced zone. With limited reserves all credible interventions must be intra-marginal with respect to the official exchange rate zone. The adapted principle with unofficial narrow zones within broad zones in the EMS is the only appealing policy, as all interventions at the borders of an official zone signal non-credibility to the market (cf Labhard and Wyplosz, 1996). Any visit and intervention at the official border of the zone has to be compensated by a gamble about a regime collapse. This gamble must be randomized on the underlying control variable. It is formally shown why there do not exist any critical limits for the reserves that ensure a credible behavior of the exchange rate within a target zone regime (cf Flood and Garber, 1991; Krugman & Rotemberg, 1990).