Exchange rate theory and practice: Target zones and asymmetrical currency substitution

This dissertation consists of two independent but related chapters on exchange rate theory and practice. The first chapter analyzes the modelling target zone exchange rate system. Besides reviewing the major studies on this issue, it provides an extension to the standard model of Krugman (1991). In its standard form, the target zone model of Krugman (1991) cannot explain sufficiently the mechanism of target zone exchange rate systems like those of the European Monetary System and the Nordic countries. The major reason is that these target zone systems lack perfect credibility and the announced exchange rate parities are occasionally realigned. Also, the central banks lean against the wind and intervene mostly before the parity hits the zone limits. The model in this chapter allows for a realignment in the central parity of the exchange rate while the fundamentals follow a mean-reverting Brownian motion which models the intramarginal interventions of the central banks. We argue that, with these extensions, the model accounts well for the empirical facts.; The second chapter develops a model of asymmetrical currency substitution. The friction for exchange rate determinacy is provided by costly spot market transactions. A stationary equilibrium with asymmetrical currency substitution exists if and only if the cost of spot market transactions is greater than either country's money growth rates, and the country 1 money growth rate is lower than that of country 2, given that country 2 has a stronger currency. When the countries cooperate, there are two optimal money growth rates that maximize the steady state utility of the consumers. The optimal money growth rate strictly decreases in currency substitutability and the cost of income taxation. When they do not cooperate, there is a unique positive Nash money growth for country 1 which increases in response to increases in country 2 money growth if the transaction costs are not too high. Finally, the results suggest that country 1 should cooperate with the developed country and choose the higher optimal money growth rate if it is greater than the Nash money growth rate.