What Happens When Countries Peg Their Exchange Rates?: The Real Side of Monetary Reform
Posted: 28 Apr 1998
Date Written: 1997
Many countries have adopted a fixed exchange regime in the context of a macroeconomic adjustment program in the hope of rapidly reducing their rate of inflation. Following the peg these economies tend to experience an increase in GDP, a large expansion of production in the non-tradable sector, a contraction in tradables production, a current account deterioration, an increase in the real wage, and a sharp appreciation in the relative price of non-tradables. There is a large literature that discusses the effects of the disinflation that follows the peg. This paper discusses a complementary channel of effects, associated with changes in the expected behavior of fiscal policy. A fixed exchange rate regime tends to be associated with an improvement, from the standpoint of the private sector, in the expected path of fiscal variables. Fiscal restraint is necessary to avoid speculative attacks against the currency; debt management has to be more careful; seignorage can no longer be used to finance increases in government spending before elections; and the more transparent costs of government activity provide an incentive to increase government efficiency.
In a simple small open economy model these fiscal impulses can help explain many of the symptoms experienced by economies that peg their exchange rate. This suggests that the real side of monetary reforms may play an important role in shaping the effects of fixed exchange rate experiences.
JEL Classification: F41, F30, F31
Suggested Citation: Suggested Citation