The Choice of Exchange Rate Bands: Balancing Credibility and Flexibility

Abstract

This paper develops a framework for the optimal choice of exchange rate bands within an environment in which policymakers dislike nominal exchange rate variability, but value the flexibility to adjust the nominal exchange rate in order to attain real exchange rate objectives in the face of stochastic shocks to the current and capital accounts of the balance of payments. The paper features imperfect reputation about the limited commitment ability of policymakers. It provides an endogenous characterization of the optimal exchange rate band in terms of the underlying distribution of shocks and of the reputation of policymakers. The effects of the position of the exchange rate within the band, and those of other parameters, on the credibility of the band are also investigated.

JEL Classification: F31, F33