Why Exchange Rate Bands? Monetary Independence in Spite of Fixed Exchange Rates

Abstract

The paper argues that real world fixed exchange rate regimes usually have finite bands instead of completely fixed exchange rates between realignments because exchange rate bands, contrary to the textbook result, give central banks some monetary independence even with free international capital mobility. The nature and amount of monetary independence is specified, informally and in a formal model, and quantified with Swedish krona data. The amount of monetary independence thus achieved appears sizeable. For instance, an increase in the Swedish krona band from zero to about +2% may reduce the krona interest rate's standard deviation by about 1/2.

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