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Title: |
Optimal Currency Target Zones: How Wide Should
Exchange Rate Bands Be? |
| Author: |
Im, Joon-Hwan |
| Author
Affiliation: |
Sogang U |
| Source: |
International Economic Journal, Spring 2001, v. 15, no. 1, pp. 61-93 |
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Publication Date: |
Spring 2001 |
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Abstract: |
This paper presents a model of an optimal
currency band in which a central bank with an infinite time horizon
faces a trade-off between interest rate deviation costs and exchange
rate deviation costs. The bank chooses optimal intervention points in
order to minimize the value of the loss function. The paper uses the
Bellman inequalities for instantaneous control of the regulated Brownian
motion to derive an optimal currency band and optimal intervention
policy characterized by two barriers. This model derives some
interesting results. First, the width of currency band depends
positively on the uncertainty of the shock, the degree of speculative
pressure, and central bank's concern about the domestic money market
versus the foreign exchange market. Second, the central bank finds it
optimal not to intervene when the fundamental rate is inside a certain
band, whereas once it lies outside the band, the optimal policy is to
move it to the nearest boundary. |
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