The burden of intervention: externalities in multilateral exchange rates arrangements

Abstract

In this paper, we consider a multilateral target zone model that generalizes Krugman's model of a bilateral target zone. Parities are defended by manipulating money supplies in participating countries. This means that interventions aimed at one given exchange rate influence other exchange rates as well. As a result of these “externalities” shocks on each fundamental affect the whole range of exchange rates involved. Moreover, intra-marginal interventions arise endogenously, and the exchange rate distribution does not exhibit the u-shaped pattern which is typical of traditional target zones. Instead, our model gives rise to “intra-marginal targets” to which exchange rates tend to return. The location of these targets is shown to depend on the intervention–sterilization mix adopted by monetary authorities.