- Email: [email protected]
Why have a target zone?
Carnegie-Rochester North-Holland
Conference Series on Public Policy 38 (1993) 315-318
Why have a target A comment
zone?
Robert P. Flood International
Monetary
Fund, Washington,
D.C. 20431, USA
and
Michael G. Spencer International
Monetary
Fund, Washington,
D.C. 20431,
USA
In this paper Krugman and Miller argue that an important motivation for introducing exchange-rate target zones has been the desire to eliminate excessive volatility resulting from “irrational” traders.’ Thus, in the absence of a target zone, exchange rates would not simply be more volatile because they float freely, as in the canonical model of Krugman (1991), but they would in fact be surprisingly volatile because of the activity of “irrational” traders. Krugman and Miller develop an example in which the presence of stoploss traders in a foreign-exchange market, controlling relatively large portfolios and with similar trigger points, can lead to surprisingly high volatility when these rules are well-understood by other traders who follow traditional strategies even during periods when no stop-loss trades are carried out. The basic idea is that the traditional traders anticipate the actions of the stoploss traders and compete against other traditional traders to ensure that the stop-loss trades are not expected to lead to excess profits. The method of analysis is familiar from Krugman’s work on anticipated speculative attacks (see Krugman (1979)) - at the instant of the stop-loss trade, market expectations adjust to ensure that the stop-loss quantities are absorbed into traditional portfolios without discrete price jumps. The cost of this price continuity is an altering of the shape of the reducedform relation between the exchange rate and market fundamentals. Rather than the usual linear free-float relation, the stop-loss strategy implies an 'We use “irrational” elements
present
in the pedantic
explicitly
0167-2231/93/$06.00
sense meaning
behavior
that
is unmotivated
by
in the model.
0 1993 - Elsevier Science Publishers B.V.
All rights reserved.
inverted-S
shape.
The stop-loss
strategy,
therefore,
makes the exchange
more volatile, given the volatility of the fundamentals, been if only traditional traders were present.
rate
than it would have
The imposition of a target zone between the upper and lower trigger points can eliminate stop-loss trading and thereby greatly reduce the volatility of the exchange rate. In the partial equilibrium framework adopted in the paper, this volatility reduction is a tasty free lunch. Krugman and Miller argue that the imposition of target zones was motivated by a desire to eliminate the excess volatility associated with irrational behavior like stop-loss trading. This claim is not well-supported by their anecdotal evidence. They concede that the EMS, the only true target zone, was not motivated by such considerations, and the quotes of Paul Volcker seem to suggest more of a fear of occasional bubbles or speculative attacks than a worry about day-to-day volatility. Moreover, if the Louvre accord to set up a target zone was intended to eliminate stop-loss trades, why was it not made public? The analysis raises other questions: 1. The paper suggests two shapes for the relationship between fundamentals and the exchange rate: the inverted-S shape with high volatility for nontarget-zone countries and the now-standard S-shaped one with a low volatility for countries in a zone. Is that prediction borne out? The answer is “yes and no.” From the work of Flood, Rose, and Mathieson (1991), it is pretty clear that target-zone countries have a different relationship between the exchange rate and fundamentals than have nontarget-zone countries. The Flood, Rose, and Mathieson analysis did not show, however, that nontarget-zone countries displayed excess volatility as compared to the prediction of models with only traditional traders, which was taken to be the primary motivation for the target zone by Krugman and Miller. 2. If removing the effects of stop-loss or other nontraditional market behavior is an important motive for target zones, then should not targetzone currencies look different from other currencies in efficiency tests, i.e., tests to see if the forward rate is an unbiased predictor of the future spot exchange rate? In Flood, Rose, and Mathieson and in the oral presentation of this comment, it was shown that typical forward market efficiency tests look about the same in the EMS as they look outside the EMS. The presence of something like stop-loss trading outside the target zone could give peso-problem-type reasons for efficiency-test failures outside the zone, or the zone might alter the risk of foreign-currency contracts. In either case, the zone tests should look different from the nonzone tests. Why then is the failure in the zone so similar to the failure outside?
Alternatively,
what might we look at in asset markets 316
or elsewhere
to see if things like stop-loss
of the foreign-exchange
market
by target
induced risks are driven out zones?
3. Finally, if setting an exchange-rate zone is such a great idea, why not go all the way and actually fix the rates rather than adopt the target zone? The authors ask this question early in the paper but never return to it explicitly. We wish they had for this is, perhaps, the most interesting question of all. In particular, what is the right-size target zone? How big a zone will achieve the desired stabilization while at the same time allowing monetary policy to follow divergent short-run cross-country policies? Is the free lunch mentioned earlier in this comment really free, or is there some “off-balance-sheet” exposure that is not explored in the paper?
317
References Flood, R.P., Rose, A., and Mathieson, D., (1991). An Empirical Exploration Carnegie-Rochester Conference Series on of Exchange-Rate Target-Zones, Public Policy, 35, (eds.) Holland.
A.H. Meltzer and C. Plosser.
Amsterdam:
North-
Krugman, P., (1979). A Model of Balance-of-Payments Crises and Devaluation, Journal of Money, Credit and Banking, 11: 311-325. Krugman, P., (1979). Target Zones and Exchange Rate Dynamics, Journal of Economics, 106: 669-682.
318
Quarterly
Conference Series on Public Policy 38 (1993) 315-318
Why have a target A comment
zone?
Robert P. Flood International
Monetary
Fund, Washington,
D.C. 20431, USA
and
Michael G. Spencer International
Monetary
Fund, Washington,
D.C. 20431,
USA
In this paper Krugman and Miller argue that an important motivation for introducing exchange-rate target zones has been the desire to eliminate excessive volatility resulting from “irrational” traders.’ Thus, in the absence of a target zone, exchange rates would not simply be more volatile because they float freely, as in the canonical model of Krugman (1991), but they would in fact be surprisingly volatile because of the activity of “irrational” traders. Krugman and Miller develop an example in which the presence of stoploss traders in a foreign-exchange market, controlling relatively large portfolios and with similar trigger points, can lead to surprisingly high volatility when these rules are well-understood by other traders who follow traditional strategies even during periods when no stop-loss trades are carried out. The basic idea is that the traditional traders anticipate the actions of the stoploss traders and compete against other traditional traders to ensure that the stop-loss trades are not expected to lead to excess profits. The method of analysis is familiar from Krugman’s work on anticipated speculative attacks (see Krugman (1979)) - at the instant of the stop-loss trade, market expectations adjust to ensure that the stop-loss quantities are absorbed into traditional portfolios without discrete price jumps. The cost of this price continuity is an altering of the shape of the reducedform relation between the exchange rate and market fundamentals. Rather than the usual linear free-float relation, the stop-loss strategy implies an 'We use “irrational” elements
present
in the pedantic
explicitly
0167-2231/93/$06.00
sense meaning
behavior
that
is unmotivated
by
in the model.
0 1993 - Elsevier Science Publishers B.V.
All rights reserved.
inverted-S
shape.
The stop-loss
strategy,
therefore,
makes the exchange
more volatile, given the volatility of the fundamentals, been if only traditional traders were present.
rate
than it would have
The imposition of a target zone between the upper and lower trigger points can eliminate stop-loss trading and thereby greatly reduce the volatility of the exchange rate. In the partial equilibrium framework adopted in the paper, this volatility reduction is a tasty free lunch. Krugman and Miller argue that the imposition of target zones was motivated by a desire to eliminate the excess volatility associated with irrational behavior like stop-loss trading. This claim is not well-supported by their anecdotal evidence. They concede that the EMS, the only true target zone, was not motivated by such considerations, and the quotes of Paul Volcker seem to suggest more of a fear of occasional bubbles or speculative attacks than a worry about day-to-day volatility. Moreover, if the Louvre accord to set up a target zone was intended to eliminate stop-loss trades, why was it not made public? The analysis raises other questions: 1. The paper suggests two shapes for the relationship between fundamentals and the exchange rate: the inverted-S shape with high volatility for nontarget-zone countries and the now-standard S-shaped one with a low volatility for countries in a zone. Is that prediction borne out? The answer is “yes and no.” From the work of Flood, Rose, and Mathieson (1991), it is pretty clear that target-zone countries have a different relationship between the exchange rate and fundamentals than have nontarget-zone countries. The Flood, Rose, and Mathieson analysis did not show, however, that nontarget-zone countries displayed excess volatility as compared to the prediction of models with only traditional traders, which was taken to be the primary motivation for the target zone by Krugman and Miller. 2. If removing the effects of stop-loss or other nontraditional market behavior is an important motive for target zones, then should not targetzone currencies look different from other currencies in efficiency tests, i.e., tests to see if the forward rate is an unbiased predictor of the future spot exchange rate? In Flood, Rose, and Mathieson and in the oral presentation of this comment, it was shown that typical forward market efficiency tests look about the same in the EMS as they look outside the EMS. The presence of something like stop-loss trading outside the target zone could give peso-problem-type reasons for efficiency-test failures outside the zone, or the zone might alter the risk of foreign-currency contracts. In either case, the zone tests should look different from the nonzone tests. Why then is the failure in the zone so similar to the failure outside?
Alternatively,
what might we look at in asset markets 316
or elsewhere
to see if things like stop-loss
of the foreign-exchange
market
by target
induced risks are driven out zones?
3. Finally, if setting an exchange-rate zone is such a great idea, why not go all the way and actually fix the rates rather than adopt the target zone? The authors ask this question early in the paper but never return to it explicitly. We wish they had for this is, perhaps, the most interesting question of all. In particular, what is the right-size target zone? How big a zone will achieve the desired stabilization while at the same time allowing monetary policy to follow divergent short-run cross-country policies? Is the free lunch mentioned earlier in this comment really free, or is there some “off-balance-sheet” exposure that is not explored in the paper?
317
References Flood, R.P., Rose, A., and Mathieson, D., (1991). An Empirical Exploration Carnegie-Rochester Conference Series on of Exchange-Rate Target-Zones, Public Policy, 35, (eds.) Holland.
A.H. Meltzer and C. Plosser.
Amsterdam:
North-
Krugman, P., (1979). A Model of Balance-of-Payments Crises and Devaluation, Journal of Money, Credit and Banking, 11: 311-325. Krugman, P., (1979). Target Zones and Exchange Rate Dynamics, Journal of Economics, 106: 669-682.
318
Quarterly