Target zones : theory and evidence

Abstract: In three papers we analyze the effects on different economic variables of implementing explicit target zones for economic policy. The first paper examines and tests two different models for devaluations in a target zone. In the model of Bertola & Caballero (1992), devaluations take place only at the boundaries, while in Bertola & Svensson (1991), devaluations can occur anywhere within the target zone. We combine these two models into a more general model of devaluations and derive its implications. We test the main conclusions of the model, using data for the EMS-currencies for the period 1979:03:13-1990:05:19. It turns out that there are few general conclusions to draw from the study. In terms of our model, different intervention strategies seem to dominate for different currencies and in different time periods. However, in general, credibility within the EMS seems to have increased up to 1990: estimated rates of devaluation have declined. In the second paper, we formally derive the implications for the nominal interest rate of implementing a target zone for the price level, when control is pursued via monetary interventions. Contradicting the conclusions of Eichengreen & Garber (1991), we show that this policy rule does not imply a stable target zone for the nominal interest rate. For price levels within boundaries, the nominal interest rate will be bounded. However, as the price level reaches either boundary, the intervention will shift the "target zone" for the nominal interest rate. We derive the implications for finite maturity interest rates and test these using data for the U.S and Sweden in the post-war period. In the third paper, we extend the model of paper two to include price rigidities: the price level adjusts sluggishly to changes in aggregate demand or supply. In this case, we show that targets for the price level in addition imply "unstable" targets for the real interest rate and output.