Exchange Rate Economics: Theories and Evidence

12 The economics of fixed
exchange rates, part 1
Target zone models
So far in this book we have considered the determination of exchange rates when
the exchange rate is freely floating. We now turn to the determination of exchange
rates when exchange rates are fixed. It may seem odd to consider the determination
of a price which is fixed,however,as Svensson and others have argued there is
really no such thing as a truly fixed exchange rate (monetary unions aside). If
we take the Classical Gold Standard period,in which participating currencies
were fixed to each other because they first of all fixed their currency in terms of
gold,there was nonetheless some exchange rate flexibility because of the costs of
shipping gold between countries and certain opportunity costs (such as the funds
tied in shipping gold). These costs set-up bands above and below the central parity
which are referred to as a target zone. Admittedly,such bands were very narrow,
but nonetheless some have argued (see,for example,Svensson 1994 and Bordo
and MacDonald 2005) that they conferred on the government of the day some
autonomy in the operation of its monetary policy (we consider this point in more
detail later). The existence of target zones in other fixed rate regimes is perhaps
clearer since such regimes have explicit bands above and below the central parity
(in the Bretton Woods regime currencies were allowed to float by plus or minus
1% relative to the central rate,while in the ERM of the EMS the bands ranged
from plus or minus 2.5% to plus or minus 15%). How then are exchange rates
determined within such bands?
As Krugman (1991) notes,a naive interpretation of how exchange rates likely
behave within a band would be to say that they behave like flexible rates until they
hit the edge of the band,whereupon the regime switches to a fixed exchange rate.
However,such an interpretation is not correct since the existence of the bands
constrains the future behaviour of the exchange rate and if agents are forwardlooking
this should affect the behaviour of the exchange rate within the band.
Expectations formation is therefore a crucial aspect of the determination of target
zone exchange rates.
In this chapter we consider the target zone literature. We start in the next section
with what is usually referred to as the base-line model,based on the simple flexprice
monetary approach equation first introduced in Chapter 4. We then go on
to develop the model using a sticky-price variant in Section 12.3. The empirical
evidence is considered in Section 12.4.