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Endogenous Realignments and the Sustainability of a Target Zone.

We examine the effects of endogenously determined realignment expectations in a model of a target zone with sluggish price adjustment. We allow these expectations to be based on a policy rule that generates an increasing probability of realignment as output moves away from full employment. We find that for realistic parameter values, even relatively small misalignments of the currency band lead to strongly skewed conditional distributions for the nominal exchange rate, thus generating pressures for realignment. We show that the reason for this is that the speed of adjustment in the absence of realignments is rather slow. Further, we find that the existence of an equilibrium path for the exchange rate depends on the responsiveness of realignment expectations to economic fundamentals. Paradoxically, higher credibility may increase the probability that a target zone will collapse. This feature of the model provides a possible explanation for the crisis within the exchange rate mechanism of the EMS. A policy of monetary accommodation to real shocks can alleviate the problem but severely constrains a country?s ability to pursue counterinflationary measures within the band.

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