On the Value of Words: Inflation and Fixed Exchange Rate Regimes

To maintain price and exchange rate stability, many emerging market and developing countries (EMDCs) de facto peg their exchange rates, intervening in the foreign exchange markets, but without formally committing to a peg. But in doing so, are they foregoing important benefits in terms of lower inflation? We argue that the de jure commitment, by making exit more costly, imparts greater credibility, which better anchors inflationary expectations, thereby leading to lower inflation than de facto pegging alone. Our empirical analysis, based on a novel data set of IMF de jure and de facto exchange rate regime classifications for 146 EMDCs over 1980–2010, finds that inflation is indeed lower—especially in emerging markets—by some 4 percentage points when the central bank both de jure commits and de facto pegs the exchange rate than when it de facto pegs alone. Thus, analogous to inflation targeting, where the formal commitment to the framework is thought to help anchor inflationary expectations, the de jure commitment to the peg may also be important to reap the full price-stability benefits of pegs.