How Tight Should Central Bank’s Hands be Tied? Credibility, Volatility and the Optimal Band Width of a Target Zone.

This paper analyzes the linkages between the credibility of a target zone regime, the volatility of the exchange rate, and the width of the band where the exchange rate is allowed to fluctuate. These three concepts should be related since the band width induces a trade-off between credibility and volatility. Narrower bands give less scope for the exchange rate to fluctuate but may make agents perceive a larger probability of realignment which by itself increases the volatility of the exchange rate. We build a model where this trade-off is made explicit. The model is used to understand the reduction in volatility experienced by most EMS currencies after their target zones were widened on August 1993. As a natural extension, the model also rationalizes the existence of non-official, implicit target zones, suggested by some authors.