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“WAIT AND SEE” OR “FEAR OF FLOATING”?

Published online by Cambridge University Press:  07 September 2020

Xiaowen Lei ,
Dong Lu  and
Kenneth Kasa
Xiaowen Lei
Affiliation:
University of Oxford
Dong Lu*
Affiliation:
Renmin University of China
Kenneth Kasa
Affiliation:
Simon Fraser University
*
Corresponding author: Dong Lu, School of Finance, Renmin University of China, No.59 Zhongguancun St. Haidian District, Beijing, China. e-mail: donglu@ruc.edu.cn. Phone: +8613522150737.
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Abstract

This paper studies the evolution of China’s exchange rate policy using real options theory. With intervention costs and ongoing uncertainty, intervention involves the exercise of an option. Increased uncertainty increases the value of this option. This “wait and see” effect leads the Central Bank to widen its intervention band. However, increased volatility also produces larger fluctuations in welfare, which creates a “fear of floating.” This induces the Central Bank to set a tighter band. To study this trade-off, our paper incorporates stochastic volatility into a new Keynesian target zone model and then calibrates it to data from China. We find that increased uncertainty leads to a tighter intervention band, both in the data and in the model. Hence, in China, “fear of floating” appears to dominate the “wait and see” effect.

Keywords

Exchange RateTarget ZoneOption ValueStochastic Volatility
Type
Articles
Information
Macroeconomic Dynamics , Volume 26 , Issue 4 , June 2022 , pp. 833 - 884
Copyright
© 2020 Cambridge University Press

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Footnotes

We would like to thank Klaus Adam, Paul Beaudry, Michael Devereux, Edouard Djeutem, Geoffrey Dunbar, Martin Ellison, Meiyu Li, Dimitry Matveev, Jun Nie, Luba Petersen, Walter Steingress, Michael Tseng, David Vines, Vivian Yue, Lei Zhang, Hang Zhou, and Wenyu Zhu for useful comments. We thank seminar participants at the 2018 European Econometrics Society Winter Meeting, Bank of Canada, Hong Kong University, and University of Oxford. We have also benefited from comments by Hua Guan, Wei Huo, Lifeng Peng, and Guofeng Sun at the People’s Bank of China. Jialin Liu, Yu Xia, and Zinan Zhou provided expert research assistance. We appreciate the constructive comments provided by three anonymous referees and the associate editor, which improved the paper significantly. Dong Lu acknowledges that this research is supported by the Key Program of National Social Science Foundation (19AJY028).

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