Target zones: A theoretical and empirical approach to exchange rate determination and the use of optimal monetary policies

The first chapter of this dissertation analyzes a stochastic rational expectations macro model and target zones exchange rate regime in the context of optimal control policies. In the literature of target zones, monetary authorities are usually taken as being passive so long as the exchange rate is inside a band. This assumption negates the possibility of exploiting the degrees of freedom in pursuing domestic targets that the zones allow with respect to fixed exchange rates. We allow the central bank to be active and, according to its preferences, to achieve some targets. This attitude generates a domestic (as opposed to an institutional ) exchange rate band. This result enables us to explain the occurrence of intramarginal interventions. Also, by allowing the fundamentals to follow more general stochastic process, different results from the standard literature are derived. The second chapter analyzes a two-country stochastic rational expectation model under alternative hypotheses on central banks behaviors. In exploring the exchange rate dynamics under a target zones regime of when additional source of stochasticity coming from the foreign economy is introduced, severe technical problems arise and an analytical or even a numerical solution may fail to exist. This limits the use of the standard target zones model and stimulates future investigation toward alternative formulation of target zones capable of coping with more general assumption. In the third chapter we explore the issue of designing optimal monetary policies to achieve some desirable paths of growth of domestic variables when international financial markets are integrated and investors are risk averse. The presence of a foreign risk premium and a target zones band on the exchange rate increase the central bank\u27s opportunities of maneuvering both interest rates and exchange rates, unless the limit of the band are reached to stabilize the economy toward its golden age path of growth. We quantify this increased freedom of the central bank by simulating alternatives scenarios with the use of the Bank of Italy Quarterly Econometric Model