Full text of Economic Commentary (Federal Reserve Bank of Cleveland) : Target Zones for Exchange Rates, August 1, 1986

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money, the actual inflation rate will
not change. However, in the case of an
unexpected increase in the budget
deficit, target zones will not work well.
The appreciation of the dollar resulting
from the higher credit demands associated with the deficit will induce an
increase in the money supply that is
likely to be inflationary. In the last
case, having target zones is apparently
not an optimum policy.
Many countries, nevertheless, believe
that the benefits of limiting the fluctuations of their currencies exceed the
costs. Most developing nations continue
to peg their currencies to the currencies
of their major trading partner, or to an
index made up of the weighted average
value of their major trading partners'
currencies. For example, Hong Kong
seems to peg its currency to the U.S.
dollar. The major European countries,
including Germany, and France, have
established the European Monetary System, a target-zone arrangement whereby
participants, except Italy, establish central exchange rates and limit the fluctuations of their currencies to within
2.5 percent of these central rates.
Among the major developed countries,
only the United States, Canada, Japan,
and the United Kingdom allow their
currencies to float in a wider sense.
The countries that fix their currencies are usually countries highly dependent on foreign markets for the
goods they consume and for the sale of
their output. They are small countries

8. See Owen F. Humpage and Nicholas V.
Karamouzis. "The Dollar in the Eighties," Economic Commentary, Federal Reserve Bank of
Cleveland, September I, 1985.

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in the sense that changes in their
domestic demand and supply conditions
have virtually no effect on international
prices. Often, the sensitivity of their
export and import demands to exchangerate changes is relatively low; consequently, exchange-rate changes may not
have the desired effect on their balance
of trade. If foreign demand for such a
country's goods falls off; the resulting
depreciation of its currency might
improve its exports, but it also will
greatly increase the cost of its imports.
Exchange-rate changes often have
major effects on prices and on wage
negotiations in the small country.
Often these countries do not have a
very diversified set of industries so that
a large segment of the economy is
influenced by developments in a single
market. Nevertheless, even small countries periodically break their pegs with
larger ones when the costs in terms of
inflation and competition elsewhere in
the world become too great.
The United States does not fall into
the small-country category. For a large
country with a relatively small trading
sector like the United States, addressing
balance of payments problems through
exchange-rate changes seems a better approach than using macroeconomic policy.
Yet, credible target -zone arrangement
could require just the opposite.

Conclusion

other economic factors, such as
changes in interest rates and inflation
differentials among countries. Ultimately, exchange rates reflect the prevailing package of macroeconomic policies among countries. If current
exchange rates appear to be volatile or
out of line relative to their equilibrium
values, it is because the underlying
monetary and fiscal policies are volatile
and unsustainable.
Limiting flexibility of exchange rates
without the necessary coordination of
macroeconomic policies will not provide
a solution to macroeconomic imbalances.
The imbalances will show up elsewhere
in the economic system. For example,
the rapid acceleration of the money supply in the United States in the early
1970s under the Bretton Woods fixed
exchange-rate system, led to rapid accumulation of dollar reserves by foreign
central banks, to the expansion of foreign money supplies, and to higher world
inflation. The Bretton Woods Agreement
could not guarantee policy coordination.
The maintenance of target zones narrow enough to eliminate the uncertainty associated with exchange-rate volatility requires a rather close degree of
macroeconomic coordination. Ironically, if countries achieve and maintain a
mutually consistent set of monetary,
fiscal, and trade policies, a system of
rigid target-zones becomes unnecessary.
Coordination and cooperation itself
could maintain exchange-rate stability.

Exchange rates are endogenous variables. This means they do not move on
their own. Exchange rates respond to
9. Gilles Oudiz and Jeffery Sachs, "Macroeconomic Policy Coordination among the Industrial
Economies," Bookings Papers on Economic Actioity, 1984:1, pp. 1·75.

10. Iagdeep S. Bhandari, ed. Exchange Rate
Management under Uncertainty. Cambridge,
Massachusetts and London, England: The MIT
Press, 1985.

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Federal Reserve Bank of Cleveland

August 1, 1986
ISSN 0428·1276

ECONOMIC
COMMENTARY
In recent years, growing dissatisfaction
with the levels and the volatility of dollar exchange rates has led to calls for
greater coordination of economic policies
among nations and for an investigation
into alternative exchange-rate systems.
A number of economists and policymakers, for example, have advocated
limiting the fluctuations of the dollar
with a target-zone arrangement for
exchange rates. Under such a proposal,
countries would establish central exchange rates values for their currencies
and would keep the actual exchange
rates within a specific margin of the
central values.
For instance, if Germany, Japan, and
the United States agree on central rates
of 150 yen to the dollar and 2.1 marks
to the dollar, and set the permissible
bands around the central rate at 10
percent, then these countries would
keep the actual yen-dollar exchange
rate between 142.5 to 157.5 yen to the
dollar and would keep the actual markdollar rate between 1.99 and 2.20
marks to the dollar.
Specific proposals about target zones
differ with respect to how the central
rates are chosen and with respect to
the width and rigidity of the margins.'
All proposals, however, seem to share
the conviction that a target-zone system will improve the functioning of the
international monetary system. In this
Economic Commentary, we argue that
establishing and maintaining target
zones presents several conceptual and
practical problems, and that such a

Owen F. Humpage is an economist with the Federal Reserve Bank of Cleveland. Nicholas V.
Karamouzis is an assistant professor in the
Department of Economics at Case Western Reserve
University in Cleveland, Ohio.
The views stated herein are those of the authors
and not necessarily those of the Federal Reserve
Bank of Cleveland or of the Board of Governors of
the Federal Reserve System.

system might not represent the best
policy choice for a large country like
the United States.

Why Target Zones?

Since the adoption of floating exchange
rates in March 1973, exchange rates
have been more volatile than under the
fixed exchange-rate system that existed
after World War II as a result of the
1944 Bretton Woods Agreement, and
have demonstrated a tendency for large
cumulative deviations from so-called
"equilibrium" values. Critics of floating
exchange rates argue that the excessive
volatility and cumulative movements of
exchange rates impose significant economic costs on the United States and
on her trading partners.s
Exchange-rate volatility, according to
proponents of target zones, disrupts
international trade and investment by
increasing uncertainty about prices and
profits. Individuals engaged in international commerce must expend resources
to hedge against foreign-exchange risk
or reduce their involvement in international trade. Persistent deviations of
exchange rates from their "equilibrium" values alter relative prices
among countries with the consequence
of distorting consumption, production,
and investment. Critics of floating exchange rates cite the record appreciation of the dollar between 1980 and
1985 as a major factor in the slow recovery of American agriculture, and of
U.S. tradable-goods industries.
A target-zone system could provide
the basis for internationally agreedupon management of exchange rates.
Proponents contend that target zones,

1. See, for example: Ronald I. McKinnon, An
International Standard for Monetary Stabilization,
Institute for International Economics: Washington, DC, Distributed by MIT Press, March 1984;
Robert V. Roosa. "Exchange Rate Arrangements
in the Eighties," The International Monetary System: Forty Years After Bretton Woods, Conference

Target Zones for
Exchange Rates?
by Owen F. Humpage and
Nicholas V. Karamouzis

by limiting exchange-rate volatility,
offer international traders a stable
anchor on which to establish prices, to
compare profits, and to plan investment across countries. The establishment of a set of target exchange rates
and the greater exchange-rate stability
is also considered a way to reduce distortions in relative prices across countries, thus minimizing costly and inefficient shifts in resources.
Moreover, proponents contend that
target zones would offer greater flexiblity than the old fixed-rate Bretton
Woods system. The zones would be
wider, and they could be adjusted frequently to offset changes in inflationrate differentials. Thus, advocates of
such systems believe that target zones
combine the best features of both the
fixed and flexible exchange rates.

Mechanics of Target Zones

If countries are to establish and to
maintain target zones, they must agree
on a definition of the central rates, on
the size of the bands around the central
rates, on a mechanism for defending the
target rates, and on a means for adjusting the central rate. Each of these
concerns presents special problems.
The central rates chosen for a targetzone system should reflect, as closely
as possible, the equilibrium value of the
exchange rate. Unfortunately, economists agree neither on what determines
an equilibrium exchange rate, nor on a

Series No.28, The Federal Reserve Bank of Boston, May 1984; and John Williamson, The
Exchange Rate System, Institute For International
Economics, Washington, DC: Distributed by MIT
Press, September 1983.

precise method for identifying changes
in the equilibrium rate. Many exchangemarket analysts define equilibrium in
terms of a rate consistent with differences in inflation rates across countries,
with a balance in the trade accounts, or
with a sustainable trade imbalance.'
Sometimes, however, the equilibrium
exchange rates associated with inflationrate differentials conflict with the equilibrium suggested by an evaluation of
trade flows. For example, consumer
prices in japan have risen 12 percent
since late 1980, while the comparable
figure for the United States was 27
percent. As will be discussed later,
these inflation differentials, taken by
themselves, suggest that the yen
should trade at approximately 180 yen
to the dollar. On the basis of this criterion, the yen, which was recently trading at 158 per dollar, seems overvalued
and should depreciate. Nevertheless,
japan continues to run a huge trade
surplus, especially with the United
States. This suggests that a further
appreciation of the yen is in order. In
view of this conflicting signal about the
equilibrium value of the yen, it seems
unlikely that a target zone based on
inflation differentials would prove
satisfactory to critics of the U.S.Japanese trade situation.
Nevertheless, most advocates of target
zones would choose a central exchange
rate that maintains some version of
purchasing power parity.' Purchasing
power parity argues that exchange
rates should adjust over time to offset
inflation differentials among nations.
If, for example, the United States experiences a 27 percent inflation rate and
japan experiences a 12 percent inflation
rate, the dollar should depreciate 15
percent against the yen to maintain the
competitive position of U.S. traded
goods. In the absence of such a depreciation, U.S. goods would become more
expensive relative to japanese goods.
Trade would shift away from American
products towards japanese products,
resulting in an excess supply of dollars

and an excess demand for yen at existing exchange rates. The imbalance
could only be corrected by a depreciation of the dollar, by contraction of the
U.S. money supply, or by an expansion
of the japanese money supply.
From a practical standpoint, the correct purchasing power parity level of
an exchange rate is difficult to calculate. It assumes that "equilibrium"
existed in the base year, and that the
price indexes used to measure inflation
trends in both countries are similar ..
Moreover, it assumes the relative prices
of non trade goods to traded goods in
both countries remains the same. None
of these assumptions seem to hold.
Other factors besides inflation differentials also can alter the equilibrium exchange rate. Productivity differentials,
technology changes, changes in tastes,
and changes in trade laws can all change
the relationship between relative-price
changes among countries and exchangerate movements, independent of the
inflation process. In a target-zone system, therefore, policy makers have to
identify these changes and allow exchange rates to reflect them. This
implies that periodic, discrete adjustments might be necessary to a targetzone system using purchasing power
parity to define the central rates.
Purchasing power parity relies on
inflation differentials to define equilibrium exchange rates and on tradedgoods arbitrage to force exchange-rate
adjustments. Recent experience has
shown, however, that capital flows can
dominate trade flows and dictate trends
in exchange rates for long periods of
time. This is especially true for a country like the United States, which has
well-developed, highly liquid capital
markets. Between 1982 and 1984, for example, the United States has experienced a growing trade deficit, a situation
most economists expected would lead to
a dollar depreciation. The dollar, how-

ever, actually appreciated through February 1985 to levels well above that predicted DYpurchasing power parity, largely because of strong capital inflows.
This sharp deviation from purchasing power parity, however, was not
inappropriate in view of the supply and
demand for credit in the United States.
These credit demands, associated with
large federal deficits and better investment opportunities, exceeded domestic
savings; thus, real interest rates rose.
The appreciation of the dollar reflected
a flow of foreign savings into dollardenominated assets; that is, it reflected
an efficient allocation of international
resources as capital moves into the
country with the highest rate of return.
Under a target-zone system, however, if federal deficit reductions are
not acceptable, policy makers would
have to accommodate the increased
federal and private credit demands by
increasing the money supply growth
rate. Such a policy eventually would
generate inflation. Between 1980 and
1985, floating exchange rates enabled
the Federal Reserve to focus monetary
policy on eliminating inflation. It is not
clear, therefore, that target zones
would have made the United States
better off between 1980 and 1985.
A second difficulty in establishing a
viable target-zone system is the choice
of acceptable bands around the central
exchange-rate targets. The bands must
be close enough to provide certainty
about the exchange rate, but wide
enough to provide some monetary policy independence. If the bands are too
narrow and countries are not willing to
adjust domestic policies sufficiently,
frequent changes in the central exchange rate will be necessary. However, since exchange-rate changes often
will create winners and losers among
the participant countries, negotiations
about the need for a change and about
the necessary extent of a change in the
central rates could take time. This
could contribute to exchange-rate uncertainty about the timing of changes.
With the spot exchange rate against
either the upper or the lower exchange-

rate band, speculators know the direction of the adjustment in the central
exchange rate, and the resulting speculation could aggravate the pressures for
a change in the central rates. Moreover,
if the adjustment in the central rate
was large, greater than the width of the
bands, speculators would face no risk
of loss in buying or selling at the rate
dictated by the bands."
Most observers seem to choose bands
of approximately 10 percent to 15 percent. Williamson seems to support nonrigid bands for which the choice of
defending or not defending the currency
would depend on the circumstances,"
It is difficult to see how this would
increase confidence in the stability of
the spot exchange rate, especially if
participants frequently adjusted the
central rates.
Nations engaged in a target-zone
arrangement must defend their
exchange rates within the bands. This
can present problems if the requirements of the target-zone arrangement
are not consistent with the purely
domestic designs for economic policy.
The problem results because nations do
not possess enough policy instruments
to pursue independent inflation and
exchange-rate targets." With fiscal
policy targeted on short-run fluctuations in real business activity, and
monetary policy directed towards maintaining a specific inflation rate, nations
must be willing to accept the resulting
exchange-rates configuration. If
nations, instead, focus monetary policy
on maintaining rigid exchange rates,
they must accept the inflation that
results from this exchange-rate policy.
Nations that successfully maintain a
target-zone arrangement will find that
their inflation rates tend to converge.
Any change in the inflation rate among
the participant countries will require a
cooperative effort. In effect, a targetzone arrangement requires that countries coordinate their monetary policies.
Consequently, target zones sometimes
can force policymakers to accept a different inflation rate than they otherwise would.

To better understand the difficulties
of maintaining a target-zone arrangement, imagine what would have happened.if the United States functioned
with such an arrangement over the last
six years. The dollar initially began appreciating in 1980. As we argued elsewhere, the appreciation initially reflected a tightening of monetary policy in the
United States." Later the appreciation
seemed to reflect an improved investment climate and the huge increase in
the federal budget deficit, both of which
raised real interest rates in the United
States. Under a target-zone situation,
the United States would have needed either to reduce its federal budget deficit
or to increase the money supply to avoid
an exchange-rate appreciation. It seems
unlikely that the administration would
cut military spending or raise taxes
because of the dollar's exchange rate,
so the burden would have fallen on monetary policy. The United States would
have had to increase its money supply
greatly to maintain the dollar, but monetary policy at this time was primarily
concerned with reducing the rate of
inflation and quieting inflation expectations. We would have had to accommodate public and private credit demands
at the risk of rekindling inflation.
Alternatively, foreign countries could
have conducted a more restrictive monetary policy in order to maintain the
exchange-rate targets. Most developed
countries were experiencing a very
sluggish recovery over the last six
years, however, and could ill-afford a
restrictive policy.
This brings up an important issue.
Maintaining target zones requires coordination of macroeconomic policies and
goals among the leading industrial countries. Unfortunately, there is no evidence that coordination of macroeconomic policies will benefit all of the
participant countries simultaneously, or
that those that benefit the most would
compensate those that benefit least. A
recent study, for example, suggests
that the benefits to the United States
from coordinating policies with other
industrial countries are rather small."
Moreover, differences in countries'
institutional structures and policy

2. Some economists have argued that excessive
exchange-rate volatility results from speculative
runs and inefficiency in the market. This could
offer a justification for intervention. Nevertheless, we believe that the empirical evidence on

this issue is inconclusive. At most, speculative
runs and inefficiency would seem to explain only
a small part of the dollar's behavior in recent
years. See, for example, Jeffery A. Frankel, "The
Dazzling Dollar," Brookings Papers on Economic
Activity, 1985, pp. 199-27.

3. See Owen F. Humpage and Nicholas V. Karamouzis, "A Correct Value for the Dollar?" Economic Commentary, Federal Reserve Bank of
Cleveland, January I, 1986.

4. The Exchange Rate System offers an alternative criterion, but the practical difficulties of
implementing Williamson's standard are not significantly less than those discussed here for
implementing purchasing power parity.

7. Some analysts, advocate the use of sterilized
exchange-market intervention-that
is, using
purchases and sales of foreign exchange, that do
not alter domestic money growth, to maintain
independent inflation and exchange-rate targets.
Unfortunately, theory and experience have

5. See The Exchange Rate System, pp. 65-67.
6. See The Exchange Rate System, pp. 62-72

objectives limit the extent to which
they can coordinate macroeconomic policies. Issues about when to adjust,
about what instruments to adjust, and
about which countries would do the
adjusting when exchange rates appear
inconsistent with fundamentals were
never resolved in the Bretton Woods
system. Proponents of target zones
have not offered satisfactory solutions
of their own.
If industrialized countries do not
coordinate macroeconomic policies, the
original exchange-rate targets will soon
become unsustainable. Then a system
of frequent discrete jumps in exchange
rates might replace the current system
of floating exchange rates. A system of
frequent, small jumps in exchange
rates could create more market uncertainty than floating exchange rates, as
rumors and denials about impending
adjustment in the central rates filter
through the market. Such a system
would not represent an improvement.
Is Limiting Exchange-Rate
Flexibility an Optimum Policy?
Several studies have shown that limiting exchange-rate flexibility is not always the best policy.'? The optimum
degree of exchange-rate flexibility depends on many factors, including: the
objectives of policymakers, the nature
and persistence of shocks that hit the
economy, the relative size of the tradegoods sector, the degree of price rigidity, and the formation of expectations.
Assume, for example, that monetary
policy focuses on maintaining a fixed
exchange rate. Given an initial stance
for monetary policy, an increase in the
demand for money, like the ones we
observed in the United States in 1983
and 1985, will tend to appreciate the
currency. To prevent an exchange-rate
appreciation, however, the central bank
will supply additional reserves to the
banking system. With the supply of
money increasing just enough to
accommodate the increased demand for

shown that sterilized intervention can have only
a temporary impact on exchange rates, so it does
not provide an independent policy instrument.
(See Humpage - forthcoming).