Optimal Target Zones: How an Exchange Rate Mechanism Can Improve Upon Discretion

Using Krugman's (1991) target zone model, we find an explicit, sub-game perfect solution for a central bank wishing to stabilize the exchange rate given proportional costs of intervention. We demonstrate, however, that precommitment to narrower bands would yield a welfare gain - which provides a theoretical rationale for an Exchange Rate Mechansim (ERM). Numerical simulations suggest that the optimal currency band with precommitment via an ERM is only half as wide as that under discretion.