Currency bands allow exchange rates to fluctuate within a set range, providing stability and a benchmark for investors. They offer some monetary independence but can also lead to instability if the exchange rate ventures too far from the permitted range.
A currency band, also known as a target zone, is the range within which an exchange rate with a particular foreign currency is allowed to fluctuate. Exchange rates are produced by the international financial market. They depend on the expectations of investors, which in turn are based on the monetary policies of the country in which the currency is based. When a country implements a currency band, its monetary policy becomes dependent on the behavior of a target foreign currency because the financial regulator must make decisions that cause the value of the local currency to change in a way that approximates changes in the foreign currency value. target currency The target zone approach preserves some of the country’s monetary independence because it does not need to hold 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, which was 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 internal economies. Despite a defense of floating rates published in 1953 by Milton Friedman, concerns persisted about the instability of unregulated exchange rates. Currency bands combined aspects of both systems.
The original reason behind the introduction of currency bands was investment stabilization. By roughly fixing exchange rates, they discourage speculation by investors hoping to take advantage of jumps in exchange rates. They also provide investors with a benchmark on which to base their expectations of future exchange rates. Countries can inspire confidence in their currency by creating a currency band that pegs the currency to a reputable target currency. A currency band also allows the country or currency union some independence in its monetary policy from fixed exchange rates, alleviating credibility concerns.
However, the independence that the currency band was designed to allow can be a source of instability, and the credibility problem is not fully resolved. If the exchange rate ventures to the extremes of the permitted range, the central monetary authority may decide that bringing it back to the center would be too difficult or would involve policy challenges that it does not want to make. Instead, you can realign the band to create a new target exchange rate. Realignment expectations can lead investors to engage in a speculative attack, where they buy bonds in one currency and avoid the other because they believe the exchange rate will change in a way that will make their purchases profitable.
Smart Asset.
Protect your devices with Threat Protection by NordVPN
