Gains from Commitment: The Case for Pegging the Exchange Rate

Abstract

This paper argues that the exchange rate regime matters for inflation and economic activity, with substantial benefits arising from a currency peg. At the heart of these benefits lies an increase in credibility that reduces the inflationary bias once central banks commit to peg their currency to a credible anchor. Using an open economy model, we provide a credibility estimate for 170 economies for 1950-2019 which aligns with other central bank independence measures. We document that committing to a peg persistently lowers inflation and its volatility while increasing real growth. Less credible countries benefit more from fixing the exchange rate.

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