Realignment Expectations, Forward Rate Bias, and Intervention in an Optimizing Model of Exchange Rate Adjustment

The paper models an adjustable peg exchange rate arrangement as a policy rule with an escape clause under which the timing and magnitudes of realignments are the outcomes of policy optimization decisions. Under the assumptions that market participants are rational, risk averse, and fully informed about the incentives of policymakers, the analysis focuses on the implications for relating realignment expectations, the interest differential, and the risk premium to the state variables that enter the policy objective function, for modeling the bias in using forward exchange rates to predict future spot rates, and for characterizing the effectiveness of sterilized intervention.