This paper discusses the profound difficulties of maintaining fixed exchange rates in a world of expanding global capital markets. Contrary to popular wisdom, industrialized-country monetary authorities easily have the resources to defend exchange parities against virtually any private speculative attack. But if their commitment to use those resources lacks credibility with markets, the costs to the broader economy of defending an exchange-rate peg can be very high. The dynamic interplay between credibility and commitment is illustrated by the 1992 Swedish and British crises and the 1994-95 Mexican collapse. We also discuss the small number of successful fixers.

The Mirage of Fixed Exchange Rates

The use of forward interest rates as a monetary policy indicator is demonstrated, using Sweden 1992-1994 as an example. The forward rates are interpreted as indicating market expectations of the time-path of future interest rates, future inflation rates, and future currency depreciation rates. They separate market expectations for the short, medium and long term more easily than the standard yield curve. Forward rates are estimated with an extended and more flexible version of Nelson and Siegel's functional form.

https://www.nber.org/system/files/working_papers/w4871/w4871.pdf

Estimating and Interpreting Forward Interest Rates: Sweden 1992 - 1994

The exchange-rate regime is often seen as constrained by the monetary policy trilemma, which imposes a stark tradeoff among exchange stability, monetary independence, and capital market openness. Yet the trilemma has not gone without challenge. Some argue that under the modern float there could be limited monetary autonomy; others, that even under the classical gold standard domestic monetary autonomy was considerable. This paper studies the coherence of international interest rates over more than 130 years. The constraints implied by the trilemma are largely borne out by history.

/pdf/the-trilemma-in-history-tradeoffs-among-exchange-rates-49j4vmqmt9.pdf

The Trilemma in History: Tradeoffs among Exchange Rates, Monetary Policies, and Capital Mobility

The incompatibility of pegged exchange rates, international capital mobility and national	monetary autonomy is a basic postulate of open economy macroeconomies. In the present environment of high capital mobility and political uncertainty, even the possibility that	governments may utilize their policy autonomy can defeat efforts to peg the exchange rate.	This leaves two possibilities. One is to fix the exchange rate irrevocably through monetary unification. The other is to live with floating rates. Either way, a case can be made for "throwing sand in the wheels" of international finance. Where monetary unification is not an option, this is a may to make distinct national currencies tolerable and international money and capital markets compatible with modest national autonomy in monetary and macroeconomic policy. For. EU counties striving to create a monetary union, it is the only politically and economically feasible way of completing the transition to Stage III of the	Maastricht process.

Two Cases for Sand in the Wheels of International Finance

The paper examines the transmission mechanism of monetary policy in an open economy with and without a binding zero bound on nominal interest rates. In particular, a foolproof way of escaping from a liquidity trap is presented, consisting of a price-level target path, a devaluation of the currency and a temporary exchange rate peg, which is later abandoned in favor of price-level or inflation targeting when the price-level target has been reached. This will jump-start the economy and escape deflation by a real depreciation of the domestic currency, a lower long real interest rate, and increased inflation expectations. The abandonment of the exchange-rate peg and the shift to price-level or inflation targeting will avoid the risk of overheating. Some conclusions for Japan are included.

/pdf/a-foolproof-way-of-escaping-from-a-liquidity-trap-2sap96ww6b.pdf

A Foolproof Way of Escaping from a Liquidity Trap

This paper proposes a tractable and realistic nonlinear model of exchange rate dynamics, and argues that its predictions are consistent with available empirical evidence on exchange rate and interest differential behavior in real-life target zones. In our model, the exchange rate fluctuates between given boundaries for random lengths of time and jumps discretely when devaluations occur. We allow for stochastic variability in the likelihood and size of devaluations, and we provide explicit solutions for the stochastic processes followed by the exchange rate and by the expected rate of depreciation. The model produces realistic patterns of covariation between exchange rates and interest rate differentials, and provides interesting interpretations of available empirical evidence. We also specify how to infer devaluation risk from target zone data.

https://papers.ssrn.com/sol3/Delivery.cfm/nber_w3576.pdf?abstractid=226829&mirid=1

Stochastic Devaluation Risk and the Empirical Fit of Target Zone Models

In the model of this paper, an exchange rate fluctuates between given boundaries for random lengths of time and jumps discretely when devaluation occur. We provide explicit solutions for the stochastic processes followed by the exchange rate and by the expected rate of depreciation when the likelihood and the size of devaluations vary stochastically over time. The model produces realistic patterns of covariation between exchange rates and interest rate differentials, and provides interesting interpretations of available empirical evidence. We also specify how to infer devaluation risk from target zone data.

/pdf/stochastic-devaluation-risk-and-the-empirical-fit-of-target-3xebe1s02c.pdf

Stochastic Devaluation Risk and the Empirical Fit of Target-Zone Models

https://www.nber.org/system/files/working_papers/w3466/w3466.pdf

The Foreign Exchange Risk Premium in a Target Zone with Devaluation Risk

The paper discusses what we have learned from last year's currency crises in ERM and the Nordic countries about fixed exchange rates as a means to achieve price stability. After discussing the explanations for the crises, the paper concludes that fixed exchange rates are not a shortcut to price stability. Monetary stability and credibility have to be built at home and cannot easily be imported from abroad. Fixed exchange rates are more fragile and difficult to maintain than previously thought. They may even be in conflict with price stability, by inducing a procyclical destabilizing monetary policy, and by inducing an inflation bias. Building monetary credibility is even more important with flexible exchange rates.

Fixed Exchange Rates as a Means to Price Stability: What Have We Learned

https://www.nber.org/system/files/working_papers/w3374/w3374.pdf

Lars E.O. Svensson

Papers

Stochastic Devaluation Risk and the Empirical Fit of Target Zone Models

Stochastic Devaluation Risk and the Empirical Fit of Target-Zone Models

The Foreign Exchange Risk Premium in a Target Zone with Devaluation Risk

Fixed Exchange Rates as a Means to Price Stability: What Have We Learned

The term structure of interest rate differentials in a target zone: Theory and Swedish data