Optimal target zones: How an exchange rate mechanism can improve upon discretion

Using Krugman's (1991) target zone model, we find an explicit, subgame-perfect solution for a central bank wishing to stabilise the exchange rate given proportional costs of intervention, We demonstrate, however, that precommitment to narrower bands would yield a welfare gain - which provides a theoretical rationale for an Exchange Rate Mechanism (ERM). Numerical simulations suggest that the optimal currency band with precommitment via an ERM is only half as wide as that under discretion, and that the welfare benefits are sufficient to sustain the system