Schedule

3. Exchange Rate Target Zones and "Dirty Floating"

3.1. Endogenous Stabilization through Target Zones
3.2. The Credibility of Target Zones

4. Exchange Rate Crises and Speculative Attacks

4.1. The Collapse of Unsustainable Fixed Exchange Rates
4.2. Crises and Multiple Equilibria: The Second Generation Model
4.3. The Crisis in South-East Asia and "Third Generation" Models of Exchange
Rate Crisis
4.4. Indicators for Exchange Rate Crises
Target Zones and Dirty Floating

Motivation:

• if excessive exchange rate volatility is caused by speculative

activity, economic policy should intervene to reduce volatility

• measures: Tobin tax, bandwidth and target zones for exchange

rates
The Tobin Tax

Idea
Small proportional tax on all foreign exchange market
transactions in order to “throw sand into the wheels of
international finance” and to reduce excess volatility was
proposed by Tobin (1978).

Intended Effect
Reduction of short-term speculative capital movements
without constraining long-term capital movements and cross-
border trade.
The Tobin Tax

How it should ideally work

• consider investment over a horizon h in domestic and

foreign assets
• assume given domestic and foreign interest rates p.a. (i and i*)
• for simplicity: no changes in exchange rate expected
• proportional Tobin tax rate is t
The Tobin Tax

Comparison of Rates of Return

• investment of one unit of domestic currency abroad leads to
tax payment of t units of currency
• return of investment times holding period h yields gross
return 1+i*h
• proportional transaction tax t is to be paid upon repatriation
of investment plus return
• net return (after tax): (1-t)(1+i*h)-t
The Tobin Tax

Compare after-tax return of domestic investment with

investment abroad

• investment in foreign country more profitable, if

(1 − t )(1 + i * h ) − t > 1 + ih
2t
i+
⇒ i* > h >i
1− t
 Effects of Tobin Tax

 the tax creates a wedge between the domestic and foreign

returns, even at the same interest rate

 due to the nonlinearity in h, the required interest rate

differential for profitable foreign investment will increase
more than proportionally with decreasing time horizon h
 The Tobin Tax

Note:
If agents expect the exchange rate to change, the above results
on the required interest rate differential carry over with slight
modications.
Additional aspects

• In fundamentalist-chartist models introduction of a tax is mostly

stabilizing
• even if short-term capital movements are most strongly affected, a
certain distortion of trade flows and long-term capital movements is to
be expected
• missing in the above analysis is the liquidity provision of short-term
transactions
• market participants might be able to find startegies to avoid taxation
(new types of derivatives, offshore markets): question of appropriate
tax base and regional coverage
• international cooperation is necessary to introduce Tobin tax, free-rider
problem
• use of the revenue: who collects the tax and what should this revenue
be used for?
 Target Zones as a Means to Stabilize Forex Markets

• The successful standard example: the European Monetary System pre

EURO
• Various uni-lateral target zones or fixed exchange rates vis-à-vis major
currencies ($, €, currency baskets), currency board
• Repeated proposals for target zone mechanism between major
currencies (($, €, ¥):
– Plaza communique of the G5 (1985), Louvre accord (1987): coordinated
interventions to prevent speculative bubbles
– McKinnon plan (1988) fixed nominal exchange rates between Europe,
Japan, U.S.A. according to PPP rates with 5% target zones
– Williamson: fixed rates at BoP equilibrium, 10% target zones
– more recently: Robert Mundell
• Note: in standard monetary models: fixed exchange rates increase
autonomy of domestic economic policy, here: target zones or fixed
exchange rates as a way to reduce volatility
Target Zones and Dirty Floating

Surprising result:

In addition to its 'trivial' effect of forcing the exchange rate to

remain within the specified bandwidths, a target zone leads to an
additional stabilizing effect via the expected interventions at the
boundaries of the target zone (so-called honeymoon effect, see
Krugman 1991).
Now stabilizing!
s t = x t + δE t [s t +1 ]
Stabilizing and destabilizing expectational feedback:

Starting Point: the monetary foreign exchange market model:

s t = x t + σ{E t [s t +1 ] − s t },

In which fundamental factors are assumed to follow a random walk:

x t +1 = x t + ε t .
Assuming strictly rational expectations (i.e. no rational
speculative bubbles):
E t [s t +1 ] = s t ⇒ s t = x t
Two types of market participants:

1.Feedback traders use so called stop-loss strategies that should

limit losses during phases of strong exchange rate volatility:
sell/buy if exchange rate hits upper/lower threshold (ssell or sbuy)

2. Rational traders who form 'correct' rational expectations like in

the standard model, and know of the existence of the feedback
traders.
 Target Zones and Dirty Floating

Consequence:
Because the exchange rate may hit sbuy or ssell and thereby trigger
stop-loss strategies, rational agents now have to incorporate this
possibility into their expectations, leading to

st = xt + σ {Et [ st +1 ] − st } ⇒ st ≠ xt
≠0
 Target Zones and Dirty Floating

More precisely:
s sell + s buy
>
> s t if s t <
E t [s t +1 ] <
2
and therefore
s sell + s buy
> x t if s t <
st < > .
2

⇒ Because rational agents anticipate the possibility of the

activation of stop-loss strategies, the speculative appreciation or
depreciation will already occur before the trigger point and
deviations from xt are already observed within the interval
[s buy , s sell ].
 Target Zones and Dirty Floating

The precise shape of the exchange rate function can be derived

with the help of the following criteria that a solution under rational
expectations has to obey:

• there should be no predictable jumps (to exclude speculative

profits)

• the exchange rate change at sbuy/ssell should be correctly

predicted (RE)
Fig. 1: Relationship between the exchange rate and the
fundamental values with stop-loss strategies
Note:
• even in the presence of entirely rational agents, existence of
heuristic strategies leads to deviations from fundamental
value
• … even before the heuristic strategies are activated!
• existence of rational speculators increases volatility and
price distortion
• … and leads to earlier activation of the trigger point!

The reverse of this mechanism explains the

Honeymoon effect of a target zone
Target Zones and Dirty Floating

Honeymoon effect of a target zone

• we assume the same fundamental exchange rate model,

• central bank sets upper and lower bounds for the exchange
rate,
• if the bounds are reached, the central bank intervenes in
order to avoid a further appreciation or depreciation,
• market participants believe in the central bank's
announcement (it is 'credible') and form their (rational)
expectations accordingly.
 Target Zones and Dirty Floating

In analogy to the first case:

< > s max + s min
E t [s t +1 ] > s t if st < ,
2
and therefore
st = xt + σ {Et [st +1 − st ]}⇒ s t ≠ xt
≠0

But because of mean-reverting expectations we have now:

< > s max + s min
st > x t , if s t < .
2
 Target Zones and Dirty Floating

Rationality of expectation formation implies:

• there should be no predictable jumps (to exclude

speculative profits)

• the exchange rate at smin/smax should be correctly

predicted (RE)
Fig. 2: Relationship between the exchange rate and fundamental
factors in a target zone
Target Zones and Dirty Floating

Observations:

• the destabilizing expectational mechanism under flexible

exchange rates is transformed into an endogenously
stabilizing mechanism,
• the expectation of central bank interventions in the foreign
exchange market weakens the effect of fundamental shocks,
• the credible announcement of a target zone lowers the
probability of reaching the exchange rate bounds, such that
there will be less need for interventions.
Formal analysis of the exchange rate dynamics

 start with the monetary

exchange rate model: s t = x t + σ{E t [s t +1 ] − s t }
 assume: symmetric bounds
around the central parity
which equals 0
s t ∈[-s , s ]

 via expectations, exchange

s t = H( x t , s )
rate depends on
fundamentals and width of
target zone

We now want to determine H(.)

 H(.) satisfies: s t = H( x t , s ) = x t + σ{E[H( x t +1, s ) ] − H( x t , s ) }

 Fundamentals follow x t +1 = x t + ε t
random walk
with E[ε t ] = 0 and Var[ε t ] = σε2

 Taylor series expansion:

ε 2t
H(x t +1, s ) = H( x t , s ) + ε t H′( x t , s ) + H′′( x t , s ) + ...
2
 Exchange rate expectation:

1
E[H(xt +1 , s )] = H ( xt , s ) + E[ε t ] H ′( xt , s ) + E[ε t2 ] H ′′( xt , s )
2
=0 =σ ε2

1 2
= H(xt , s ) + σ ε H ′′
2

Equilibrium exchange rate

becomes:
σ
st = H ( xt , s ) = xt + σ ε2 H ′′( xt , s )
2

“Distortion” due to expected interventions

Solution for H(.):

 2   2 

st = xt + A1exp  
xt  + A2 exp − xt 
 σσ 2
ε   σσ 2
ε 

A1,A2: constants of integration

Since at parity xt = st = 0:

A2 = -A1 ≡ A and

s t = x t + A[exp(ρx t ) − exp(−ρx t )] 2
with ρ =
= x t + 2A sinh(ρx t ) σσε2
There is one more constant to determine:

 define the point where the s = x + 2Asinh(ρx)

exchange rate coincides with the
bound:

 it also holds that: H′( s , x) = 0

 hence: 1 + Aρ[exp(ρx) + exp(-ρx))] = 0

1
⇒A=−
2ρ cosh(ρx )

1 sinh(ρx t )
st = x t −
ρ cosh(ρx )
Empirical evidence

Honeymoon effect can be tested with the following model

implications:

1. The observed distribution of the exchange rate between

both bounds should be u-shaped.

2. The target zone mechanism should generate a negative

relationship between the interest rate differential and the
exchange rate because of UIP.
 U-shaped distribution?

Fig. 3: Theoretical distribution of the exchange rate in a target zone Fig. 4: Empirical distribution of the exchange rate in a target zone

Source: Gärtner/Lutz (2004, S.326)

EMS: post crisis
 Inverse relationship between exchange rate and
interest rate?

Assuming UIP, we conclude that

Fig. 5: Theoretical relationship between the exchange rate and the interest

< s max + s min

rate differential in a target zone

E t [s t +1 ]<> s t for s t >

2

*> < s max + s min

⇔ i t − i t < 0 for s t >
2

Source: Gärtner/Lutz (2004, S.327ff)

Empirical evidence:

Fig. 6: Empirical relationship between the exchange rate and the interest rate differential

Source: Gärtner/Lutz (2004, S.327ff)

EMS, post crisis
Target Zones and Dirty Floating

Possible explanations for empirical failure:

1. Additional intra-marginal interventions

2. Imperfect credibility of the target zone

Example: EMS realignments, expectations mechanism works

insufficiently under imperfect credibility.
 decomposition of
exchange rate into parity st = ct + yt
(ct) and deviation from
parity (yt)

 Decomposition of E t [∆s t +1 ] = E t [∆c t +1 ] + E t [∆y t +1 ]

expectations

 Honeymoon mechanism
requires absence of E t [∆c t +1 ] = 0
realignment expectations
 Fig. 5: Development of the spot and forward rate in a target zone
 expected realignments
can be “detected” via
violations of CIP

 if the interest differential

exceeds the maximum
intra-marginal changes
of a credible target zone:
market participants
expect realignment Source: Gärtner/Lutz (2004, S.326)