Endogenous realignments and the sustainability of a targetP. Dean Corbae, Christopher Neely and Paul A. Weller No 1994-009, Working Papers from Federal Reserve Bank of St. Louis Abstract: We examine the effects of endogenously determined realignment expectations in a model of a target zone with sluggish price adjustment. We allow these expectations to be based on a policy rule that generates an increasing probability of realignment as output moves away from full employment. We find that for realistic parameter values, even relatively small misalignments of the currency band lead to strongly skewed conditional distributions for the nominal exchange rate, thus generating pressures for realignment. We show that the reason for this is that the speed of adjustment in the absence of realignments is rather slow. Further, we find that the existence of an equilibrium path for the exchange rate depends on the responsiveness of realignment expectations to economic fundamentals. Paradoxically, higher credibility may increase the probability that a target zone will collapse. This feature of the model provides a possible explanation for the crisis within the exchange rate mechanism of the EMS. A policy of monetary accommodation to real shocks can alleviate the problem but severely constrains a country?s ability to pursue counterinflationary measures within the band. Keywords: Credit; Foreign exchange rates (search for similar items in EconPapers) Downloads: (external link) Related works: Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text Persistent link: https://EconPapers.repec.org/RePEc:fip:fedlwp:1994-009 Ordering information: This working paper can be ordered from Access Statistics for this paper More papers in Working Papers from Federal Reserve Bank of St. Louis Contact information at EDIRC. |
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