Soft Exchange Rate Bands and Speculative Attacks: Theory, and Evidence from the ERM since August 1993

WP/98/156-EAWP/98/156


.Soft Exchange Rate Bands and Speculative Attacks: Theory, and Evidence
from the ERM since August 1993

Prepared by Leonardo Bartolini and Alessandro Prati


Despite the interest and active research generated by target zone models, much
work remains to be done to capture the institutions and stylized facts
describing the experience of countries that have adopted target-zone-like
arrangements in recent years. In this study, we present a model of a soft
target zone with two main goals: to extend research on target zones to include
a .soft-band. policy that has long interested scholars of currency markets, but
has never received rigorous treatment; and to capture some key aspects of the
wide-band ERM intervention policy and explain its resilience against
speculation after the post-August 1993 period.


The main feature of our model is the assumption that exchange rate intervention
responds not only to the level of the exchange rate at a given point in time,
but also to its behavior over the recent past. We develop our model as a direct
extension of standard target zone models and show that, for reasonable
parameters, soft target zones should be considerably more resilient to
speculative attacks than hard target zones. This prediction is consistent with
the sharp abatement of speculative pressure in Europe since August 1993: at
that time, ERM central banks adopted a policy that, while committing to a
narrow exchange rate target over long horizons, has tolerated wider
fluctuations over short horizons. The new policy regime has brought greater
stability to European currency markets: after enduring at least two dozen
speculative attacks from August 1992 to July 1993, the ERM has been threatened
on only a couple of occasions since August 1993. Our analysis suggests that
this performance can be traced-at least in part-to European central banks.
.soft. approach to exchange rate intervention, and points to the usefulness of
this policy for other countries that target their exchange rates.