Exchange Rate Target Zone Dual-layer Monitoring Model
Exchange rate target zone model involves setting a pair of pre-specified exchange rate bands in which a central bank commits to intervene in exchange markets. This arrangement is sometimes referred to as a crawling peg mechanism Figure below illustrates the basic idea of a target zone. It is drawn as a horizontal zone around a central rate e* (the midpoint of the two bands).
At a first glance, it appears that the target zone serves as an excellent device to arrange exchange rate stabilization. The central bank, while announcing the target rate, simultaneously commits to intervene in the markets, both at the upper and the lower boundaries – depending on which of the boundaries is violated – in order to maintain the rate within the pre-specified bands.
However, this simple arrangement proved to be ineffective in many cases. During the period 1985 to 1987 and 1988 to 1992, the German central bank, the Bundesbank, attempted to maintain and stabilize the exchange rate of the German Mark (DEM) as part of the Exchange rate Mechanism (ERM) of the European Monetary System (EMS). In spite of the heavy foreign exchange interventions by the Bundesbank, the German exchange rate occasionally fluctuated outside the pre-specified ERM bands.
The difficulties in managing a target zone regime can be attributed to various factors. Firstly, the central bank is forced to intervene in the exchange markets frequently in order to keep the exchange rate within the bands. This is especially true in the case that speculators are of the view that the current exchange rate will soon exceed the upper boundary, as they will attempt to take advantage of this situation.
Secondly, the central bank has to limit its gaze of surveillance, as it cannot monitor the exchange markets all the time. Moreover, in many cases, the central bank has to stay ahead of the movements in the markets, which is a difficult task. This problem is even more pronounced when, because of the capital mobility, speculators can act more quickly than the central bank.
Finally, the exchange rate also depends on external factors, such as the current state of economies and the relationship between the two countries political, social and economical statuses. Therefore, the exchange rate cannot always be controlled by the central bank, even if it commits to intervene in the markets.
Hence, a dual-layer monitoring model (DLM) has been proposed in order to avoid these pitfalls of a single-layer target zone model. It aims to combine the advantage of the target zone model with the flexibility of a floating system. A DLM acts as a cushion that guards the central bank against unnecessary currency attacks, allowing it to delay an intervention when it is not necessary.
In a DLM, two target bands, AL and AU, are set symmetrically around the central rate e*. The two bands are considered to be a hard and a soft one, reflecting the fact that the central bank is more likely to intervene in the markets when the exchange rate reaches the hard band than the soft band. The former is set more narrowly and adjacent to the central rate, while the latter is distant from the central rate.
The greatest advantage of a DLM over a single-layer target zone is that it provides more flexibility to the central bank, as the exchange rate will not be permanently fixed within the bands. This flexibility is particularly helpful when there is an external shock to the economy or when speculators are attacking the currency, as the central bank can observe the exchange rate behavior until it reaches the hard band, when it should intervene in the markets.
Moreover, a DLM signals the commitment of the central bank to exchange stability, and thus reinforces investor confidence. This means that the probability of currency speculation is enhanced, reducing the need for the intervention of the central bank in the exchange markets.
In conclusion, exchange rate target zone dual-layer monitoring model has several benefits. It allows the central bank to observe the exchange rate until it reaches the hard band before intervening, provides more flexibility than a single-layer target zone model, and increases investor confidence. All these features allow the DLM to be used as an effective exchange rate management strategy.
