IMPORTING CREDIBILITY THROUGH EXCHANGE RATE PEGGING

Authors


  • This paper is a revised and shortened version of ‘Credible Purchases of Credibility Through Exchange Rate Pegging’, which was written during my PhD studies at European University Institute (where it appeared as a working paper, ECO 94/38, 1994). Financial support from the European Investment Bank is gratefully acknowledged. I am indebted to Alberto Giovannini for providing the original stimulus behind this research, to Kristina Kostial for thorough proof-reading and to my thesis advisor Mark Salmon and two referees of this Journal for constructive suggestions. Moreover, I have benefited from comments of and discussions with Michael Artis, Michael Begg, Alex Cukierman, Maurice Obstfeld, Matthew Rabin, Ákos Valentinyi, George von Furstenberg, and the participants of the macro-workshop at the European University Institute, the EEA-conference 1994 and the ASSET-meeting 1995, at which previous versions were presented. I take full responsibility for all errors.

Abstract

This paper employs an optimal taxation framework in order to study the credibility of monetary policy-making in an open economy. Since inflation is, in part, uncontrollable due to stochastic disturbances, the authority's actions cannot be monitored perfectly when the exchange rate floats, thus implying that reputational forces may become ineffective. In contrast, pegging the nominal exchange rate to a low-inflation currency allows perfect monitoring, because the exchange rate is, in principle, controllable. For this reason, exchange rate pegging may import credibility and result in the best reputational equilibrium, even though the authority retains the discretion to devalue unexpectedly.

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