Target Zone and International Policy Coordination

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In the literature, the virtue of policy coordination and exchange rate stability among industrialized countries has been emphasized. The need for policy coordination and the exchange rate stability was most evident during the first half of the 1980s. Policy coordination would increase welfare of the economies as it will internalize externalities of economic policies. The target zone will prevent the exchange rate misalignment which will cause real effects, and correction of the exchange rate level will take effects only with a log. In fact, it took two years before a sharp depreciation of the dollar (appreciation of the yen) contributed to correcting the imbalance of the current accounts.This research project investigates the possible detrimental effect of policy coordination among G7 countries (Japan, U. S., Germany, France, U. K., Canada, Italy). Theoretically it has been shown that the policy coordination may not increase the welfare of the economies involved in coordination. This possibility indeed emerged during the period, 1987-1989 when the G7 countries adopted a target zone.One case where coordination (in the exchange rate) results in a worse outcome is a circumstance that country A's mistake (such as deliberate inflation) in economic policy is not punished by the depreciation of the currency due to country B's adjustment (inflation) to keep the currency at the agreed level. From 1986 to 1988, G7 countries carried out coordinated interest rate cuts, which contributed to an asset inflation in Japan. The target zone policy indeed caused a detrimental effect in Japan, when the target was mistaken.