Abstracts Economics

Exchange rate target zone analysis: a theoretical and empirical approach combining imperfect credibility and foreign exchange reserve deficiencies

by Christopher M. Cornell

In this dissertation, I identify and test a model of exchange rate target zones. This model modifies the standard model to incorporate issues related to the credibility and ability of monetary authorities to maintain a target zone regime. I am responding to recent difficulties in reconciling theoretical target zone models with the data. These modifications are an economical and effective response to the failure of the empirical literature to find strong evidence of the predicted S-curve effect on exchange rates. My solution modifies the model and improves the method of testing the model. My results indicate that previous empirical studies of target zone models appear to place inadequate restrictions on the possible shape of the S-curve. In particular, I show that the so-called inverted S-curve (where exchange rates become more volatile than their underlying fundamentals) is theoretically implausible, as it implies a target zone regime must collapse if the monetary authority is ever asked to defend it. In addition, this work identifies separates target zone arrangements by their ability to withstand speculative attack. I show a solution that identifies which target zone arrangements are likely to succumb to speculative attack and which are not. Thus, it may be possible to predict possible speculative attack, even under conditions where forward and/or options markets are not open and therefore those prices cannot be used to calculate implied market forecasts of probabilities of realignment. My model also allows for policy analysis. I allow the researcher to adjust policy parameters so that they can make conclusions about how particular parameter settings affect the stability and durability of the regime being studied. This framework may be used to analyze many different fixed or nearly fixed exchange rate arrangements, including the European Monetary System (EMS), metallic standards like the gold standard (where the “gold points” are reinterpreted as target zone bands), pegged exchange rates (where only one monetary authority actively maintains the arrangement, such as is often practiced in LDCs and the newly industrialized countries of East Asia), and possible future transnational currency arrangements that may arise from the current wave of free-trade pacts.