Informal one‐sided target zone model and the Swiss franc

Abstract

This paper develops a new theoretical model with an asymmetric informal one-sided exchange rate target zone, with an application to the Swiss franc following the removal of the minimum exchange rate of CHF 1.20 per euro in January 2015. We extend and generalize a standard target zone model by introducing perceived uncertainty about the lower edge of the band. We find that informal soft edge target zone bands lead to weaker honeymoon effects, wider target zone ranges, and higher exchange rate volatility than formal target zone bands. These results suggest that it would be beneficial for exchange rate policy intentions to be stated clearly in order to anchor exchange rate expectations and reduce exchange rate volatility. We also study how exchange rate dynamics can be characterized in models in which financial markets are aware of occasional changes in the policy regime. We show that expected changes in the central bank's exchange rate policy may lead to exchange rate oscillations, providing an additional source of exchange rate volatility, and to capture this it is important to take into account the possibility of regime changes in exchange rate policy.

Foreign exchange interventions under a minimum exchange rate regime and the Swiss franc

“…The extent of this “instability” is thereby increasing in the degree of “imperfect credibility.” Consequently, the domestic monetary authority will have to intervene more heavily to maintain the target zone 53 . A similar result emerges in the informal target zone model developed by Chen et al (2018) that is also embedded within the Krugman framework and can be merged with my model to obtain a metric that allows monetary authorities to assess the expected size of FXI under an implicit minimum exchange rate regime. Last but not least, Campa and Chang (1998) summarize the implications of the most commonly used exchange rate target zone models for the shape of the distribution that relates exchange rate volatility (on the y ‐axis) to the position of the spot exchange rate within the target zone (on the x ‐axis).…”

“…All these results suggest that V t, T might indeed be an adequate tool for monetary authorities to assess the consequences of implementing and maintaining a minimum exchange rate regime in terms of the size of FXI and to monitor the timing of a major monetary policy regime switch. The documented results are also helpful for financial market participants, when a currency of interest is subject to an implicit target zone regime, as it potentially allows them to infer the policy reaction function of the monetary authority involved also in the case of an implicit exchange rate target zones: notice that my model can be extended to account for the existence of informal exchange rate bands by, for example, adopting the modeling approach in Chen et al (2018).…”

“…The sight deposit accounts may nevertheless change also for other reasons, for instance, when banks “fly‐to‐safety” (Chen et al, 2018) seeking liquidity by selling risky assets and hoarding cash. To capture this effect, the change in sight deposits could be regressed on a proxy for global equity market uncertainty (e.g.…”

Foreign Exchange Interventions Under a One-Sided Target Zone Regime and the Swiss Franc

“…35 The extent of this "instability" is thereby increasing in the degree of "imperfect credibility". A similar result emerges in the informal target zone model developed by Chen, Funke, and Moessner (2018) that is embedded within the Krugman framework and can easily be merged with my structural model, e.g. using their modification in their Subsection 4.2.…”

“…Nevertheless, the sight deposit accounts may change also for other reasons, e.g. when banks "fly-to-safety" (Chen et al, 2018), which should be borne in mind when interpreting the empirical results. Other proxy measures, such as changes in the SNB's FX reserves, are not appropriate for at least two reasons.…”