A currency band is a range within which an exchange rate can fluctuate. It combines aspects of both fixed and floating exchange rates, providing a benchmark for investors and some monetary independence for countries. However, it can also lead to instability and speculative attacks if the exchange rate drifts too far from the center of the band.
A currency band, also known as a target zone, is the range within which an exchange rate against a given foreign currency is allowed to fluctuate. Exchange rates are produced by the international financial market. They depend on investors’ expectations, which in turn are based on the monetary policies of the country where the currency is located. When a country implements a currency band, its monetary policy becomes dependent on the behavior of a target foreign currency because the financial regulatory body must make decisions that cause the value of the local currency to change in a way that approximates changes in the value of the target currency. The target zone approach preserves some of the country’s monetary independence because it does not need to keep the exchange rate at an exact level.
Currency bands are a compromise between floating or unregulated exchange rates and fixed exchange rates, where the currency is said to be pegged to a foreign currency. The International Monetary Fund, created by the Bretton Woods Agreement at the end of World War II, was created with a framework of fixed exchange rates. The system broke down due to its inflexibility; countries wanted to use monetary and fiscal tools to promote stability in their domestic economy. Despite a defense of floating rates published in 1953 by Milton Friedman, fears about the instability of unregulated exchange rates persisted. Currency bands combined aspects of both systems.
The original rationale behind the introduction of currency bands was investment stabilization. By loosely fixing exchange rates, they discourage speculation by investors hoping to take advantage of exchange rate jumps. They also give investors a benchmark on which to base their expectations about future exchange rates. Countries can inspire confidence in their currency by creating a currency band that links the currency to a reputable target currency. A currency band also allows the country or monetary union some independence in its monetary policy from fixed exchange rates, easing credibility concerns.
The independence that the currency band was designed to allow, however, can be a source of instability and the credibility problem is not fully resolved. If the exchange rate drifts to the extremes of the permissible range, the central monetary authority may decide that returning it to the center would be too difficult or would pose policy challenges that it does not want to face. Instead, it can realign the band to create a new target exchange rate. Realignment expectations can lead investors to engage in a speculative attack, in which they buy bonds in one currency and avoid the other because they think the exchange rate will change in a way that makes their purchases profitable.
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