Currency Bands, Target Zones, and Cash Limits: Thresholds for Monetary and Fiscal Policy

IMF Working Papers, February 1, 1990

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Canonical URL: Currency Bands, Target Zones, and Cash Limits: Thresholds for Monetary and Fiscal Policy

Exchange rate behavior is analyzed in the context of a stochastic rational expectations model in which there are random shocks to the price setting mechanism.
Authorities in the model choose to impose either nominal or real exchange rate bands.
Results from the stochastic rational expectations model are compared to results from a simple monetary model subject to velocity shocks.
The effects of a realignment of the Band are examined.
The effects of fiscal policy used in conjunction with monetary policy to defend the band are examined.

The paper contrasts outcomes under:
- A stochastic rational expectations framework with random shocks to price setting.
- A simple monetary model subject to velocity shocks.
Policy-relevant mechanisms analyzed include:
- Imposition of nominal exchange rate bands.
- Imposition of real exchange rate bands.
- Realignment of a Band.
- Use of fiscal policy together with monetary policy to defend a band.

The study addresses thresholds for monetary and fiscal policy when defending exchange rate bands, including:
- Implications of choosing nominal versus real exchange rate bands.
- Conditions under which realignment of a Band alters exchange rate behavior.
- Roles for fiscal policy when used in conjunction with monetary policy to defend a band.

Subject: Currencies, Exchange rates, Foreign exchange, Managed exchange rates, Monetary base, Money, Real exchange rates
Keywords: cash limit, commitments of the EMS, Currencies, currency band, exchange rate commitment, Exchange rates, full employment, Global, Managed exchange rates, Monetary base, monetary policy, money stock, price level, Real exchange rates, WP