Pegging the exchange rate to gain monetary policy credibility

Jonathan Davis and Ippei Fujiwara

No 224, Globalization Institute Working Papers from Federal Reserve Bank of Dallas

Abstract: Central banks that lack credibility often tie their exchange rate to that of a more credible partner in order to ?import? credibility. We show in a small open economy model that a central bank that displays ?limited credibility? can deliver significant improvements to a social welfare function that contains no role for exchange rate stabilization by maximizing an objective function that places weight on exchange rate stabilization, and thus the central bank with limited credibility will peg their currency to that of a more credible partner. As the central bank?s credibility improves it will place less weight on exchange rate stabilization in its objective function and thus loosen the peg. When the central bank is perfectly credible its objective function and the social welfare function are identical; it places no weight on exchange rate stabilization and allows the currency to freely float. Empirical results using a panel of both developed and developing countries show that as central banks become more independent they tend to allow more currency flexibility.

JEL-codes: E30 E50 F40 (search for similar items in EconPapers)
Pages: 34 pages
Date: 2015-01-01
New Economics Papers: this item is included in nep-cba, nep-mac, nep-mon and nep-opm
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:fip:feddgw:224

DOI: 10.24149/gwp224

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