Exchange-Rate Pegging in Emerging-Market Countries?byFrederic S.MishkinGraduate School of Business, Columbia University,andNationalBureauofEconomicResearchPhone:212-854-3488,Fax:212-316-9219E-mail:fsm3@columbia.eduJune1998I thank Adam Posen, Robert Hodrick, an anonymous referee and participants in the macro lunch atColumbia University for their helpful comments.Any views expressed in this paper are those ofthe author only and not those of Columbia University or the National Bureau of EconomicResearch
Exchange-Rate Pegging in Emerging-Market Countries? by Frederic S. Mishkin Graduate School of Business, Columbia University, and National Bureau of Economic Research Phone: 212-854-3488, Fax: 212-316-9219 E-mail: fsm3@columbia.edu June 1998 I thank Adam Posen, Robert Hodrick, an anonymous referee and participants in the macro lunch at Columbia University for their helpful comments. Any views expressed in this paper are those of the author only and not those of Columbia University or the National Bureau of Economic Research
ABSTRACTThis paperexamines the questionof whether pegging exchange rates is agood strategyforemergingmarket countries. Although pegging the exchange rate provides a nominal anchor for emergingmarket countries that can help them to control inflation, the analysis in this paper does not providesupportfor this strategy for the conduct of monetary policy.First thereare theusual criticisms ofexchange-rate pegging, that it entails the loss of an independent monetary policy, exposes thecountry tothe transmission of shocks from the anchor country, increases the likelihood ofspeculative attacks and potentially weakens the accountability of policymakers to pursue anti-inflationary policies. However, most damaging to the case for exchange-rate pegging in emergingmarket countries is that it can increase financial fragility and make the potential for financial crisesmore likely.Because of the devastating effects on the economy that financial crises can bring,anexchange-rate peg is a very dangerous strategy for controlling inflation in emerging market countries.Instead, this paper suggests that a strategy with a greater likelihood of success involves thegrantingof independence to the central bank and inflation targetingFrederic S. MishkinGraduateSchoolofBusinessUrisHall619ColumbiaUniversityNewYork,NewYork10027andNBERfsm3@columbia.eduIIntroduction
ABSTRACT This paper examines the question of whether pegging exchange rates is a good strategy for emergingmarket countries. Although pegging the exchange rate provides a nominal anchor for emerging market countries that can help them to control inflation, the analysis in this paper does not provide support for this strategy for the conduct of monetary policy. First there are the usual criticisms of exchange-rate pegging, that it entails the loss of an independent monetary policy, exposes the country to the transmission of shocks from the anchor country, increases the likelihood of speculative attacks and potentially weakens the accountability of policymakers to pursue antiinflationary policies. However, most damaging to the case for exchange-rate pegging in emerging market countries is that it can increase financial fragility and make the potential for financial crises more likely. Because of the devastating effects on the economy that financial crises can bring, an exchange-rate peg is a very dangerous strategy for controlling inflation in emerging market countries. Instead, this paper suggests that a strategy with a greater likelihood of success involves the granting of independence to the central bank and inflation targeting. Frederic S. Mishkin Graduate School of Business Uris Hall 619 Columbia University New York, New York 10027 and NBER fsm3@columbia.edu I. Introduction
In recent years, there has been a growing consensus, even in emerging-market countries, thatcontrolling inflation should be the primary or overriding long-term goal of monetary policy.Pastexperience with high inflation in emerging-market countries has not been a happy one, and there is agrowing literature that suggests that high inflation can be an important factor that retards economicgrowth. Although central bankers, as well as the public, in emerging-market countries now putmore emphasis on controlling inflation, there is still the crucial question of how best to do this. Toachieve low inflation, one choice that emerging-market countries have often made is to peg theircurrency to that ofa large, low-inflation country, typically the United States.2 Is this choice a goodone?This paper examines the question of whether pegging its exchange rate is a good strategy foremerging-market countries. The analysis here suggests that the answer is usually no, except inextreme circumstances where a particularly strong form of exchange-rate pegging might be worthpursuing.Indeed, an important point in the analysis of this paper is that pegging the exchange rateis a less viable strategy for emerging-market countries than it is for industrialized countries.After examining rationales for exchange-rate pegging, the paper discusses criticisms ofexchange rate pegging and why it is so dangerous for emerging-market countries.Because the paperargues that exchange-rate pegging is highly problematic for emerging-market countries, it then goeson to explore what other strategies for inflation control might be reasonable alternatives in thesecountries.Thepaperendswith someconcludingremarks.II.'See, for example, Anderson and Gruen (1995), Briault(1995), Bruno (1991), Feldstein (1997),Fischer(1993,1994)andSarel(1996).2In some cases, this strategy involves pegging the exchange rate at a fixed value to that of the othercountry so that its inflation rate will eventually gravitate tothat of the other country,while in othercases it involves a crawling peg or target in which its curency is allowed to depreciate at a steady rateso that its inflation rate can be slightly higher than that of the other country
In recent years, there has been a growing consensus, even in emerging-market countries, that controlling inflation should be the primary or overriding long-term goal of monetary policy. Past experience with high inflation in emerging-market countries has not been a happy one, and there is a growing literature that suggests that high inflation can be an important factor that retards economic growth.1 Although central bankers, as well as the public, in emerging-market countries now put more emphasis on controlling inflation, there is still the crucial question of how best to do this. To achieve low inflation, one choice that emerging-market countries have often made is to peg their currency to that of a large, low-inflation country, typically the United States.2 Is this choice a good one? This paper examines the question of whether pegging its exchange rate is a good strategy for emerging-market countries. The analysis here suggests that the answer is usually no, except in extreme circumstances where a particularly strong form of exchange-rate pegging might be worth pursuing. Indeed, an important point in the analysis of this paper is that pegging the exchange rate is a less viable strategy for emerging-market countries than it is for industrialized countries. After examining rationales for exchange-rate pegging, the paper discusses criticisms of exchange rate pegging and why it is so dangerous for emerging-market countries. Because the paper argues that exchange-rate pegging is highly problematic for emerging-market countries, it then goes on to explore what other strategies for inflation control might be reasonable alternatives in these countries. The paper ends with some concluding remarks. II. 1 See, for example, Anderson and Gruen (1995), Briault(1995), Bruno (1991), Feldstein (1997), Fischer (1993, 1994) and Sarel (1996). 2 In some cases, this strategy involves pegging the exchange rate at a fixed value to that of the other country so that its inflation rate will eventually gravitate to that of the other country, while in other cases it involves a crawling peg or target in which its currency is allowed to depreciate at a steady rate so that its inflation rate can be slightly higher than that of the other country
RationalesforExchange-RatePeggingFixing the value of an emerging-market's currency to that of a sounder currency, which isexactly what an exchange-rate peg involves, provides a nominal anchor for the economy that hasseveral important benefits. First, the nominal anchor of an exchange-rate peg fixes the inflation ratefor internationally traded goods, and thus directly contributes to keeping inflation under control.Second, ifthe exchange-rate peg is credible, it anchors inflation expectations in the emerging-marketcountry to the inflation rate in the anchor country to whose currency it is pegged.The lowerinflation expectations that then result bring the emerging-market country's inflation rate in line withthat of the low-inflation, anchor country relatively quickly.Another way to think of how the nominal anchor of an exchange- rate peg works to lowerinflation expectations and actual inflation is to recognize that if there are no restrictions on capitalmovements, then a serious commitment to an exchange-rate peg means that the emerging-marketcountry has in effect adopted the monetary policy of the anchor country.As long as thecommitment to the peg is credible, the interest rate in the emerging-market country will be equal tothatintheanchor country.Expansion of themoney supplyto obtainlower interest rates in theemerging-market country relative to that of the low-inflation country will only result in a capitaloutflow and loss of international reserves that will cause a subsequent contraction in the moneysupply, leaving both the money supply and interest rates at their original levels.Thus, another wayof seeing why the nominal anchor of an exchange-rate peg lowers inflation expectations and thuskeeps inflation under control in an emerging-market country is that the exchange-rate peg helps theemerging-market country inherit the credibility of the low-inflation, anchor country's monetarypolicy.A further benefit of having an exchange-rate peg as a nominal anchor in an emerging marketcountry is that it helps provide a discipline on policymaking that avoids the so-called time-inconsistency problem described by Kydland and Prescott (1977), Calvo (1978) and Barro andGordon (1983).The time-inconsistency problem arises because there are incentives for apolicymakerto pursue discretionary policy to achieve short-run objectives, such as higher growth
Rationales for Exchange-Rate Pegging Fixing the value of an emerging-market's currency to that of a sounder currency, which is exactly what an exchange-rate peg involves, provides a nominal anchor for the economy that has several important benefits. First, the nominal anchor of an exchange-rate peg fixes the inflation rate for internationally traded goods, and thus directly contributes to keeping inflation under control. Second, if the exchange-rate peg is credible, it anchors inflation expectations in the emerging-market country to the inflation rate in the anchor country to whose currency it is pegged. The lower inflation expectations that then result bring the emerging-market country's inflation rate in line with that of the low-inflation, anchor country relatively quickly. Another way to think of how the nominal anchor of an exchange- rate peg works to lower inflation expectations and actual inflation is to recognize that if there are no restrictions on capital movements, then a serious commitment to an exchange-rate peg means that the emerging-market country has in effect adopted the monetary policy of the anchor country. As long as the commitment to the peg is credible, the interest rate in the emerging-market country will be equal to that in the anchor country. Expansion of the money supply to obtain lower interest rates in the emerging-market country relative to that of the low-inflation country will only result in a capital outflow and loss of international reserves that will cause a subsequent contraction in the money supply, leaving both the money supply and interest rates at their original levels. Thus, another way of seeing why the nominal anchor of an exchange-rate peg lowers inflation expectations and thus keeps inflation under control in an emerging-market country is that the exchange-rate peg helps the emerging-market country inherit the credibility of the low-inflation, anchor country's monetary policy. A further benefit of having an exchange-rate peg as a nominal anchor in an emerging market country is that it helps provide a discipline on policymaking that avoids the so-called timeinconsistency problem described by Kydland and Prescott (1977), Calvo (1978) and Barro and Gordon (1983). The time-inconsistency problem arises because there are incentives for a policymaker to pursue discretionary policy to achieve short-run objectives, such as higher growth
and employment, even though the result is poor long-run outcomes -- high inflation. Thetime-inconsistency problem can be avoided if policy is bound by a rule that prevents policymakers frompursuing discretionary policy to achieve short-run objectives. Indeed, this is what an exchange ratepeg can do if the commitment to it is strong enough.With a strong commitment to it, the exchangerate peg eliminates discretionary monetary policy and implies an automatic policy rule that forces atightening of monetary policy when there is a tendency for the domestic currency to depreciate or aloosening of policy when there is a tendency for the domestic currency to appreciate.As McCallum(1995)haspointed out, simplybyrecognizingtheproblem thatforward-looking expectations in thewage-and price-setting process creates fora strategy of pursuingexpansionarymonetarypolicy,central banks candecidenottopursueexpansionarypolicywhichleads to inflation. However, even if the central bank recognizes the problem, there still will bepressures on the central bank to pursue overly expansionary monetary policy by the politicians thatcan lead to this outcome, so thatthetime-inconsistency problem remains:the time-inconsistencyproblem is just shiftedbackone step.Thesimplicityand clarityof anexchangeratepegcanhelpreduce pressures on the central bank from the political process because the exchange-rate peg iseasily understood by the public, providing a "maintenance of a sound currency"as an easy-to-understand rallying cry for the central bank.Thus, an exchange-rate peg can help the monetaryauthorities to resist any political pressures to engage in time-inconsistent policies.With all of these advantages of an exchange-rate peg as a strategy for controlling inflation inemerging market countries, it is not surprising that many of these countries have adopted thisstrategy? However, as we will see in the next two sections, there are sufficient dangers in pursuingan exchange-rate peg, that it may produce poor economic outcomes in most emerging marketcountries.3Another potential advantage of an exchange-rate peg is that by providing a more stable value ofthe currency,it might lowerrisk for foreign investors and thus encourage capital inflows which couldstimulate growth. However, as we will see in Section IV, capital inflows may be highly problematic foran emerging market country because they may help encourage a lending boom which eventuallyweakensthe banking sector and helps stimulatea financial crisis
and employment, even though the result is poor long-run outcomes - high inflation. The timeinconsistency problem can be avoided if policy is bound by a rule that prevents policymakers from pursuing discretionary policy to achieve short-run objectives. Indeed, this is what an exchange rate peg can do if the commitment to it is strong enough. With a strong commitment to it, the exchange rate peg eliminates discretionary monetary policy and implies an automatic policy rule that forces a tightening of monetary policy when there is a tendency for the domestic currency to depreciate or a loosening of policy when there is a tendency for the domestic currency to appreciate. As McCallum (1995) has pointed out, simply by recognizing the problem that forwardlooking expectations in the wage- and price-setting process creates for a strategy of pursuing expansionary monetary policy, central banks can decide not to pursue expansionary policy which leads to inflation. However, even if the central bank recognizes the problem, there still will be pressures on the central bank to pursue overly expansionary monetary policy by the politicians that can lead to this outcome, so that the time-inconsistency problem remains: the time-inconsistency problem is just shifted back one step. The simplicity and clarity of an exchange rate peg can help reduce pressures on the central bank from the political process because the exchange-rate peg is easily understood by the public, providing a "maintenance of a sound currency" as an easy-tounderstand rallying cry for the central bank. Thus, an exchange-rate peg can help the monetary authorities to resist any political pressures to engage in time-inconsistent policies. With all of these advantages of an exchange-rate peg as a strategy for controlling inflation in emerging market countries, it is not surprising that many of these countries have adopted this strategy.3 However, as we will see in the next two sections, there are sufficient dangers in pursuing an exchange-rate peg, that it may produce poor economic outcomes in most emerging market countries. 3Another potential advantage of an exchange-rate peg is that by providing a more stable value of the currency, it might lower risk for foreign investors and thus encourage capital inflows which could stimulate growth. However, as we will see in Section IV, capital inflows may be highly problematic for an emerging market country because they may help encourage a lending boom which eventually weakens the banking sector and helps stimulate a financial crisis