The Dangers of Exchange‐Rate Pegging in Emerging‐Market Countries

This paper examines the question of whether pegging exchange rates is a good strategy for emerging‐market 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 anti‐inflationary policies. However, most damaging to the case for exchange‐rate pegging in emerging‐market countries is that it can increase financial fragility and heighten the potential for financial crises. 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 the adoption of inflation targeting.