Front Matter Page
European Department
Table of Contents
Summary
I. Introduction
II. Monetary Models
III. A Stochastic Dornbusch Model
1. Nominal currency bands
2. Target zones
3. Discrete realignment of a currency band
IV. Cash Limits on Public Spending when the Trade Balance is in Serious Deficit: An Example of “State Contingent” Fiscal Policy
V. Summary and Conclusions
Appendix I. Monetary Targets Subject to Nominal Bands
Appendix II. Cash Limits and Exchange Rate Overshooting
References
Table 1. Varieties of Policy Response
Summary
This paper discusses how the commitment to keep a currency within prescribed limits in relation to a hard currency affects the conduct of monetary policy. It also examines how adjustments to fiscal policy may reduce the strain on the credibility of strict exchange rate commitments posed by inflationary surges in the domestic economy.
The techniques involved assume that foreign exchange markets are rational and that the authorities’ commitment to maintaining the exchange rate within the band is fully credible. Briefly, they consist, first, in seeing how the exchange rate will logically relate to economic fundamentals and, then, in determining what rules for monetary policy are consistent with keeping the currency within bands.
The paper begins with a brief survey of the literature that studies the Implications of a random walk in velocity for the conduct of policy in a flexible-price, full-employment, monetary model, where the exchange rate is always at its purchasing power parity level. In such models, monetary policy must accommodate velocity shocks beyond a certain level.
The main body of the paper considers how currency bands affect the conduct of monetary policy when prices are not fully flexible and price setting is subject to random supply side shocks. Specifically, the implications for monetary policy of pursuing nominal currency bands in a stochastic version of a well-known “exchange rate dynamics” model are examined.
As the target zones for exchange rates that have recently been advocated are for real, not nominal exchange rates, real currency bands, which are indexed to the price level, are also examined. The implications of announcing credible rules for the accommodation of cumulative price movements by discrete realignments are also briefly discussed.
The same framework is employed to determine the effects of adjustments to fiscal policy (by imposing cash limits on public spending) when the trade deficit goes beyond a critical threshold, either when the rate is floating or when it is stationary at the edge of a band. The conclusion discusses some of the limitations of the analysis, including, in particular, the assumption that financial markets are efficient and that the bands are fully credible.