How tight should one's hands be tied? Fear of floating and credibility of exchange regimes.

Abstract

The literature on exchange regimes has recently observed that officially self-declared free floaters strongly intervene their nominal exchange rates to maintain them within some unannounced bands. In this paper, we provide an explanation for this behavior, labeled by Calvo and Reinhart (2002) as fear of floating. First, we analyze the linkages between the credibility of the exchange regime, the volatility of the exchange rate and the band width of fluctuation. Second, the model is used to understand the reduction in volatility experienced by most ERM countries after their target zones were widened on August 1993. Finally, solving the model for a subgame perfect equilibrium, fear of floating can be viewed as the credible choice of a finite non-zero bandFear of floating, target zones, exchange rate arrangements, credibility