On the credibility issue of exchange rate target zones

Diplomarbeit von Matthias Rau-Göhring

Zusammenfassung:

Währungskrisen, wie die des Europäischen Währungssystems (EWS) 1992, können noch immer nur unzureichend vorausgesagt werden. Es wird jedoch anerkannt, dass die Glaubwürdigkeit eines jeden Währungssystems ausschließlich endogen bestimmt wird, d.h. durch Interaktion der einzelnen Akteure an den Wechselkursmärkten.

Die vorliegende Arbeit untersucht, ob ein bestimmtes Glaubwürdigkeitsmaß, eingeführt von Avesani, Gallo und Salmon (1995), geeignet ist, die große EWS Krise 1992 vorauszusagen. Dabei handelt es sich um ein dynamisches Spiel, in dem die beiden Akteure (Zentralbank und Finanzmarkt) miteinander interagieren und damit die Glaubwürdigkeit des Systems „aushandeln“. Es wird gezeigt, dass o.g. Glaubwürdigkeitsmaß ein geeigneter Indikator für Währungskrisen darstellt, was empirisch anhand des französischen Francs, der italienischen Lira und des niederländischen Guldens nachgewiesen wird.

Introduction:

The objective of the present study is to present the literature of exchange rate target zones and to explore empirically the Avesani-Gallo-Salmon credibility measure for selected currencies belonging to the Exchange-Rate Mechanism (ERM) of the European Monetary System (EMS). In the past decade the empirical literature on real world target zones mushroomed considerably, but still, its overall significance in explaining strains in the relevant foreign exchange markets remains relatively low. In this context, I will explore whether the Avesani-Gallo-Salmon (1995) credibility measure demonstrates more power than earlier studies in the analysis of the 1992/3 EMS crisis.

It is not my intention to pursue a normative analysis whether flexible or fixed exchange rates or intermediate regimes are superior to one another in terms of their economic implications. This question is beyond the scope of my analysis.1 Given that target zones are applied frequently in the real world, I purely want to figure out, whether their application is sensible on grounds of a firm commitment of the policy-makers.

Exchange rate bands have been discussed widely after the breakdown of the Bretton Woods System in 1973. Although experiences with the fixed exchange rate regime were disappointing in the 1960s, increased volatility and/or overshooting of the exchange rates in the 1970s let economists doubt the famous argument by Friedman (1953) that speculation would stabilize exchange rate movements in the floating system. McKinnon (1976) reckoned that there may be an insufficient amount of speculation due to institutional constraints, other economists suspected speculators to be ill-informed and therefore act in an irrational manner. However, the desire to avoid speculative pressure and crises within the foreign exchange market resulted in the IMF’s Guidelines for Floating, which entailed the possibility that a country brings its exchange rate ”within, or closer to, some target zone of rates”(see IMF (1974, p.181). In 1979 the European Monetary System was established and -although different in design- subsequently some Latin American, Scandinavian and South-East Asian countries set up unilateral target zones for their exchange rates, too. With the Plaza Communiqué of the G-5 countries in 1985 and its successor, the Louvre Accord of 1987, also the major industrial countries returned to manage their exchange rates rather than either fix or float them. Exchange-rate target zones (target zones from now on) were seen as a sensible third way of exchange rate management. They are defined by a central parity for the exchange rate and a fluctuation band around this parity.

The first comprehensive target zone proposal was made by Williamson (1983). He presented a model that subsumes the following features:

1. The monetary authority is expected to alter its monetary policy when the exchange rate approaches one of the edges of the zone.

2. The exchange rate should be kept within a published but wide zone.

3. This zone should be defined in terms of the real effective exchange-rate.

4. The central parity should be set according to the ”fundamental equilibrium exchange rate”, meaning the rate needed to reconcile internal and external balance in the medium term.

5. The zone should be adjusted in response to relevant information that alter the estimate of the equilibrium exchange rate.

In the following years this proposal for reform was discussed and improved extensively. But the debate solely concentrated on the policy design and institutional characteristics relating to target zones. It took nearly another five years until Paul Krugman presented his seminal paper on the theoretical foundations of exchange rate behaviour within target zones in end 1987, published as Krugman (1991).

Krugman’s analysis has become classical and his main argument can be understood intuitively. Figure 1 shows the exchange rate on the vertical axis, measured as the logarithm of units of domestic currency per unit of foreign currency, and the logarithms of a compound fundamental term on the horizontal axis. Given certain assumptions, Krugman (1991) shows that the rational expectations equilibrium relationship between the fundamentals and the exchange rate in a credible target zone exhibits the S-shape illustrated in figure 1. Contrary to the free float solution, as represented by the 45-degree line, the target zone solution shows a bias toward the central parity or to put it differently, the target zone creates a ”honeymoon effect” that stabilizes the exchange rate within the band. Some economists refer to this as a ”free lunch”-gain of a target zone. However, Bertola and Caballero (1992) show that imperfect or lacking credibility of the authorities’ policy may lead to an inverted S-shape for the exchange rate solution. This implies that in absence of a credible policy, target zones may have a destabilizing effect for the foreign exchange market rather than a ”honeymoon effect”. Credibility in this context is the policy makers willingness, ability and emphasis to follow the announced path of exchange rate policy rather than diverging from it.

The differences between the credible and the imperfect-credible target zone models build the motivation for my analysis. Following Bertola and Caballero (1992), policymakers should not opt for a target zone when their commitment to such a policy is relatively weak. In this context, I will focus my analysis on the aspects of the EMS, notably the exchange rates of the Lira and French Franc vis-à-vis the Deutschmark. Although there has been an intensive discussion on the credibility of the EMS, little focus was set on an endogenous evolution of credibility; merely all publications assume a fixed stock of credibility that the authority could either deplete or maintain.

To come up with an alternative assessment, which explicitly includes the endogenous evolution of credibility using the Avesani-Gallo-Salmon credibility measure, the remainder of my thesis is organized as follows: Drawing on Krugman (1991), section 2 derives the equilibrium measure of the exchange rate within a target zone and discusses both the model’s assumptions and implications. Section 3 relaxes some of the most critical assumptions and tries to infer the conclusions for the exchange rate behaviour. Section 4 presents alternative measures for credibility and examines the usefulness of the measures concerned. In section 5 the application of the Avesani-Gallo-Salmon (1995) credibility measure for the exchange rates of the Italian Lira (Lit) and French franc (FF) vis-à-vis the Deutschmark (DM) is outlined and results are interpreted. Finally, section 6 concludes.

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