Pegged Exchange Rate Regimes-A Trap?
We analyze the role of an exchange rate peg as a commitment mechanism to achieve inflation stability when multiple equilibria are possible. We show that there are "ex ante" large gains from choosing a more conservative regime not only in order to mitigate inflation bias from time inconsistency but also to avoid high inflation equilibria. In these circumstances, using a pegged exchange rate as an anti-inflation commitment device can create a "trap" whereby the regime initially confers gains in anti-inflation credibility but ultimately results in an exit occasioned by a big enough adverse real shock that creates large welfare losses to the economy. Copyright (c) 2008 The Ohio State University.
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Volume (Year): 40 (2008)
Issue (Month): 4 (06)
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