Inflation, Interest Rates and the Choice of the Exchange Rate Regime

Abstract

What is the impact of the exchange rate regime on inflation, interest rates and economic activity? In this paper we provide novel evidence surrounding the gains of a pegged exchange rate regime. We first emphasize that countries with a fixed exchange rate regime tend to have persistently lower inflation and interest rates. In addition to that, we document that volatility of nominal variables is lower with a fixed exchange rate. Last we find that countries that enter a fixed exchange rate regime tend to experience a subsequent increase in GDP growth. We rationalize these findings with a calibrated small open economy model that emphasizes the lack of commitment of central banks when the exchange rate is flexible. In such a regime, an inflationary bias arises that lowers consumption. Pegging the exchange rate to a stable anchor lowers inflation and its volatility by a similar magnitude as in the data. This persistent decline in inflation is beneficial for the economy and leads to an increase in GDP.

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