DP1253 Endogenous Realignments and the Sustainability of a Target Zone

Author(s): P Dean Corbae , Christopher J Neely , Paul Weller

Publication Date: October 1995

Keyword(s): European Monetary System , Realignments , Target Zones

JEL(s): E58 , F31 , F33 , G15

Programme Areas: Financial Economics , International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP1253.asp

We examine the effects of endogenously determined realignment expectations in a model of a target zone with sluggish price adjustment. We allow these expectations to be based on a policy rule which attaches differing weights to output and price stability. We find that for realistic parameter values even relatively small misalignments of the band lead to strongly skewed conditional distributions for the nominal exchange rate, thus generating pressures for realignment. We show that the reason for this is that the speed of adjustment in the absence of realignments is rather slow. Further, we find that variable realignment expectations impose tight limits on the width of a sustainable band. If realignment expectations reach quite moderate levels there no longer exists an intervention policy that will support the band. Finally, we show that even relatively infrequent realignments can substantially speed the process of adjustment to misalignment, casting doubt on the desirability of a policy designed to maintain a fully credible band in the face of significant external shocks.