OPTIMAL WIDTH OF THE IMPLICIT EXCHANGE RATE BAND AND THE CENTRAL BANK'S CREDIBILITY

Naci CANPOLAT (Hacettepe University)

In February 2001 currency peg regime collapsed in Turkey and the Central Bank switched to floating exchange rate regime. In an open and highly dollarized economy such as Turkey exchange rate volatility is not desirable because of its detrimental effects on inflation and output. At the beginning of 2002 monetary authorities looking for an effective way to limit exchange rate volatility have announced that foreign exchange interventions will be kept at a minimum and the Central Bank will only intervene in excessive fluctuations.

In this paper, the Central Bank's policy decision to intervene foreign exchange markets in only excessive fluctuations will be modeled as a policy rule of an implicit (s, S) form. If the exchange rate hits s or S, the Central Bank intervenes and realigns the exchange rate. In order to determine the optimal width of the implicit exchange rate band we use the methodology of statistical ruin problem for random walks. Our results suggest two points: the Central Bank adopts such a policy due to low level of reputation, and credibility of such a policy depends upon the level of foreign reserves, the nature of the disturbances and weights put on the foreign exchange fluctuation vis-à-vis inflation and output volatility.