On the evolution of credibility and flexible exchange rate target zones

Abstract

This paper considers the optimal management of exchange rate target zones by regarding the operation of a target zone as a dynamic signalling game between the monetary authorities and the financial markets. A Sequential Open Loop (Feedback) policy of sterilised intervention is proposed that depends critically on the evolution of the policy maker’s credibility as opposed to the open loop precommitment strategy that has been implemented, for instance, in the Exchange Rate Mechanism of the EMS and in the Bretton Woods system. The width of the target zone and re-alignments are in turn determined optimally given the policy maker’s credibility. This flexible target zone proposal is shown through simulation to stabilize the exchange rate to a substantial degree while retaining considerable flexibility and robustness in response to shocks