DP214 | On Optimal World Stabilization and the Target Zones Proposal

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In this paper I examine issues of optimal stabilization in two types of world economy, a competitive one where all countries are small, and one where there is a Stackelberg leader. The focus is on the 1985 target zones proposal of Williamson, according to which there should be a periodic fixing of exchange rates at levels consistent with equilibrium real rates. World monetary policy should be assigned to the objective of international monetary stability and domestic stabilization policies to the internal balance objectives of individual economies. In a first-best world, where all economies use both monetary and fiscal policy, this appears to be the optimal arrangement. In a second-best world, where fiscal policy cannot be used, the additional constraint imposed by target zones might hinder rather than promote world stabilization. However, if the only country constrained in its use of fiscal policy is the Stackelberg leader, target zones might reproduce the optimal world monetary arrangement quite closely.