Choosing the Width of Exchange Rate Bands - Credibility vs. Flexibility

The purpose of this paper is to provide a framework for the analysis of policy-makers' choices regarding unilateral exchange rate bands. Exchange rate bands are viewed as the outcome of an optimization problem by a policy-maker whose objective function weighs the level of the real exchange rate against the level and variability of the real exchange rate. The analysis endogenizes policy decisions about realignments and about the width of the band. Conditions are developed for the case in which optimal band width widens in response to a decrease in policy-makers' commitment reputation, an increase in the cost of reneging on the existing band, and an increase in the variance of fundamental shocks.