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Pegged Exchange Rate Regimes—A Trap?
Author(s) -
AIZENMAN JOSHUA,
GLICK REUVEN
Publication year - 2008
Publication title -
journal of money, credit and banking
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.763
H-Index - 108
eISSN - 1538-4616
pISSN - 0022-2879
DOI - 10.1111/j.1538-4616.2008.00138.x
Subject(s) - economics , exchange rate , credibility , inflation (cosmology) , monetary economics , shock (circulatory) , trap (plumbing) , exchange rate regime , order (exchange) , ex ante , keynesian economics , physics , medicine , finance , theoretical physics , political science , law , meteorology
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.