Importing Credibility through Exchange Rate Pegging

Author: Herrendorf B.

Source: The Economic Journal, Volume 107, Number 442, 1 May 1997 , pp. 687-694(8)

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Abstract:

This paper employs an optimal taxation framework in order to study the credibility of monetary policy-making in an open economy. Since inflation is, in part, uncontrollable due to stochastic disturbances, the authority's actions cannot be monitored perfectly when the exchange rate floats, thus implying that reputational forces may become ineffective. In contrast, pegging the nominal exchange rate to a low-inflation currency allows perfect monitoring, because the exchange rate is, in principle, controllable. For this reason, exchange rate pegging may import credibility and result in the best reputational equilibrium, even though the authority retains the discretion to devalue unexpectedly.

Language: English

Document Type: Research article

Affiliations: 1: University of Warwick

Publication date: 1997-05-01