When Do Target Zones Work? An Examination of Exchange Rate Targeting as a Device for Coordinating Economic Policies

With the European Exchange Rate Mechanism, the Louvre Accord and the Bretton Woods system, policy makers have tried to use exchange rate targeting as a means of improving economic performance. However, while initially successful, all three regimes eventually collapsed. This paper asks what makes target zones work? We show that coordination can be achieved by having all countries play a noncooperative game in which each has to take account of some of the aims of others in addition to their own. If policies are built around exchange rate targeting, this means the target path should be a projected equilibrium exchange rate, updated and amended to include the latest information on realisations of foreign as well as domestic targets. That would provide the necessary conditions for induced coordination. They are not sufficient for successful targeting however, since there is no guarantee that the coordination will be strong enough for the gains to be distributed in an incentive compatible way. Copyright Kluwer Academic Publishers 1998