The paper models an adjustable peg exchange rate arrangement as a policy rule with an escape clause under which the timing and magnitudes of realignments are the outcomes of policy optimization decisions. Under the assumptions that market participants are rational, risk averse, and fully informed about the incentives of policymakers, the paper explores the implications (1) for relating realignment expectations to the variables that enter the policy objective function, (2) for modeling the bias in using forward exchange rates to predict future spot rates, and (3) for characterizing the effectiveness of sterilized intervention.
The analysis suggests that the co-movements of realignment expectations and the risk premium may be highly correlated, pointing to the possibility of bias in the existing methodology for constructing measures of realignment expectations. It also reconciles the view that macroeconomic fundamentals are relevant to realignment expectations, with the fact that the widening of constructed measures of realignment expectations for European exchange rates, during the summer of 1992, did not coincide with significant changes in macroeconomic conditions. In addition, the conceptual framework provides a model of the premium for bearing the risk of a policy decision to adjust the exchange rate peg--the type of event on which the peso-problem literature has focused--thereby integrating two of the proposed explanations of forward rate bias that are consistent with rational expectations.
The policy optimization framework provides useful insights on the effectiveness of sterilized intervention, including that its effects on the risk premium and on expected future exchange rates are not independent of each other. When market participants have complete information about the incentives of policymakers, the effectiveness of sterilized intervention depends critically on the relative weight attached to foreign exchange valuation losses in the policy objective function. Unless an increase in exposure to valuation losses makes the authorities more reluctant to realign, other things being equal, sterilized intervention will have no effect on rational assessments of realignment prospects. Furthermore, when sterilized intervention is effective, the time variation of realignment expectations and the risk premium may depend on the extent to which there are explicit or implicit constraints on the use of sterilized intervention as a policy instrument. When completely unconstrained, intervention can be used to prevent time variation in the state of the economy from generating time variation in realignment expectations, while also greatly mitigating the time variation in the risk premium. Accordingly, in empirical attempts to relate realignment expectations or the risk premium to fundamental macroeconomic variables, it may be important to take account of institutional considerations governing the use of sterilized intervention.