Gains from Commitment: The Case for Pegging the Exchange Rate

Abstract

Does the exchange rate regime matter for inflation and economic activity? This paper argues that it does and that there are substantial benefits to a fixed exchange rate regime. At the heart of these benefits lies an increase in commitment for the central bank that reduces the inflationary bias of monetary policy. Using an open economy model we provide an estimate for the credibility of hundred different central banks between 1950 and 2016. Our empirical analysis demonstrates that after pegging the currency to a more credible anchor, the average economy benefits from persistently lower inflation of 3.5% per year, higher temporary economic growth and lower inflation volatility. Moreover, the less credible countries are the ones benefiting the most from committing to a fixed exchange rate regime.

Keywords: Exchange Rate Regimes, Monetary Policy, Interest Rates, Inflation

JEL Classification: E31, E42, E52, F41, F42