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Exchange rate bands and optimal monetary accomodation under a dirty float

  • Economics
  • Mathematics
  • Political Science


`~ ~1'IIZ Discussion 8414 1992 for a er,mic Research " IIIIIIIIIItiI~pnI tlIII I~IIIIi~IINd~~I~ No. 9213 EXCHANGE RATE BANDS AND OPTIMAL MONETARY ACCOMMODATION UNDER A DIRTY FLO7~T IioA by Roel M.W.J. Beetsma and Frederick van der Ploeg ~,~ ~ April 1)92 r~C~~ ct ~C ~Q~ ISSN 0924-7815 EXCHANGE RATE HANDB AND OPTZI~[AL MONETARY ACCOMMODATION UNDER A DIRTY FLOATa Roel M.W.J. Beetsma CentER, Tilburg University Frederick van der Ploeg University of Amsterdam and CEPR ABSTRACT This paper studies regimes of managed exchange rates for a small open economy with an integrated capital market, ratíonal expectations in finaTicial markets, sluggish nominal wages and prices, and supply shocks that follow a Brownian motíon. Each regíme can be characterised by the degree to which price shocks are accommodated and the width of the exchange rate band. Special cases of monetary accommodation are a peg, a clean float and a PPP exchange rate rule. Fírst, the optimal degree of monetary accommodation of price shocks ís analysed when there is no exchange rate band. Given that the welfare loss is a weighted sum of the asymptotic variances of output and of consumer prices, monetary accommodation is particularly strong when the authoritíes care relatively more about full employment than price stability. More flexible labour markets induce right- wing governments to move towards a cleaner float and left-wing governments towards a PPP exchange rate rule. Second, the effects of exchange rate bands and tt~e accompanying inframarginal interventions is examined when allowance is made for intramarginal interventions as well. Such a set-up can, in contrast to the píoneering Krugman model, explain the observed hump-shaped unconditíonal density functions of EMS exchange rates. Keywords: Optimal monetary accommodation, dirty floatíng, exchange rate bands, PPP exchange rate rules, exchange rate peg, interest rates, Brownian motion, price shocks, Ornstein-Uhlenbeck process, stochastic simulation. .JEl

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