Abstract
Krugman's ‘honeymoon’ seminal paper showed in 1991 the stabilizing properties of the adoption of fluctuation bands and gave rise to the literature on target zones. Subsequent contributions, however, showed that, in the absence of adequate reserves, a destabilizing ‘divorce’ would lead to speculative attacks.
The euro area public debt crisis revived that literature, producing a second generation of target zone modeling, based on the idea that the sustainability of public debt implies the adoption of an interest rate target. Its lack of credibility (if the central bank or the government does not guarantee repayment of the debt) explains the non-linearity of the relationship between interest rates and public debt that was observed during the euro area crisis. The model also makes it possible to understand why some non-euro area countries have not been subject to speculative attacks despite the fact that their public debt-to-GDP ratios were as high as those of countries in crisis, but guaranteed by the 'virtual' reserves of their national central banks. Finally, a third generation of target zone modeling is represented by its application to the current crisis of economic globalization and has been extended to merge it with heterogeneous agents modeling.
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Notes
Krugman and Miller (1992) contains a first set of important contributions. Kempa and Nelles (1999) provide an accurate theoretical and empirical overview of the large body of literature that developed approximately during the first decade of life of the exchange rate target zone literature. Duarte et al. (2013), instead, reviewed, together with the basic setup of the model, also the subsequent theoretical developments, until about 10 years ago. No significant contributions or applications have appeared after then. This is why I have used the term ‘revival’ in my paper.
One can think of the state of economic fundamentals as represented, for example, by money supply in a standard monetary model of exchange rate determination.
Duarte et al. (2013) already introduce the distinction between a ‘first’ and a ‘second generation’ of target zone modelling. In their terminology, the former is the one relative to the full-credibility ‘honeymoon’ case, while with the latter they refer to the imperfect-credibility case of ‘divorce’.
Krugman’s model assumes instead the exchange rate equation: \({s}_{t}={m}_{t}+\beta \frac{E(d{s}_{t})}{dt}\).
The ‘fundamentals-driven’ risk premium may well depend on the difference between the absolute size of the public debt-to-GDP ratio \({b}_{t}\) an expected maximum ‘safe’ value like, for example, the 60% public debt-to-GDP ratio reported in the Maastricht Treaty. Alcidi and Gros (2018), IMF (2011) and European Commission (2014), for example, consider the risk premium as determined by such a difference. It should be stressed, however, that such a value is far from objective and univocally determined but results instead from institutional and possibly also contingent choices. The value assigned to α is 0.03 in the case of developed countries (Alcidi and Gros 2018) and 0.04 in the case of developing countries (IMF 2011).
“Economists usually like to model people as calculating optimally their investment decisions based on expectations of future price changes and estimates of the risk in alternative investments” (Shiller 2000, p. 55).
See Della Posta (2019) for further details on the government debt stability condition. The dynamics of public debt might have had a more complex specification, for example in the case in which some foreign resources were available (IMF, Next Generation EU, and the like). In the present setup of the model, I do not consider those possibilities, that could be simply thought, however, as determining a larger value for \(\widetilde {m}\).
See Tamborini (2015) for further details on the conditions that have to hold for public debt sustainability.
Equation (53) also suggests that it would be possible to use as a dependent variable of the target zone model also either \(m_t\) or \(s_t\).
Normally, an anti-inflationary and independent central bank will avoid printing money when that may cause inflation, but it is difficult to imagine that a monetary authority which is caught between the need to avoid inflation and the need to avoid the bankruptcy of her own country will prefer the second option.
The equation above captures quite intuitively the fact that the costs of globalization resented by the population are both real and perceived. The role played by self-fulfilling expectations in driving human behavior is well-known, the placebo effect being probably the most famous example of it.
In what follows, also in line with the previous applications of target zone modeling, any lower target for the costs is also ignored, since we are focusing on the possible destabilizing effects resulting from an increase in the level of globalization.
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I would like to thank three anonymous referees for their precious comments and suggestions. They have allowed me to improve significantly my article. Needless to say, none of them can be held responsible for any remaining mistake.
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Della Posta, P. The Revival of Target Zone Modeling. Open Econ Rev 33, 775–805 (2022). https://doi.org/10.1007/s11079-021-09642-6
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DOI: https://doi.org/10.1007/s11079-021-09642-6
Keywords
- Target zones
- Exchange rates
- Economic fundamentals
- Speculative attacks
- Interest rates
- Public debt
- Euro area crisis
- Economic globalization
- Self-fulfilling expectations