Warwick Business School Financial Econometrics Research Centre
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
