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Effective Exchange Rate Regimes and Inflation

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  • Harms, Philipp
  • Knaze, Jakub

Abstract

This paper introduces a new effective exchange rate regime classification. Traditional classifications define the stability or flexibility of a currency with respect to one ("anchor") currency, thus implicitly neglecting information on exchange rate relationships against other currencies. Our new measure is computed as a trade-weighted average of bilateral exchange rate regimes, thus taking into account both direct and indirect relationships against all other currencies. We argue that our "effective" approach is superior when it comes to assessing the impact of exchange rate regimes on inflation, because fixing an exchange rate vis-'a-vis one currency does not completely anchor domestic prices in a world with multiple trading partners. Using our measure of effective exchange rate regimes in a standard empirical analysis of inflation determinants, we find that - compared to freely floating regimes - not only hard pegs, but also narrow and wide soft pegs are associated with significantly lower inflation rates. This challenges the established view that soft pegs do not matter - or are even detrimental - for price stability. We find that the effect of fixing the exchange rate goes significantly beyond the "disciplining effect" on money growth, with the inflation reduction being at least as strong as the effect of an official inflation target.

Suggested Citation

  • Harms, Philipp & Knaze, Jakub, 2021. "Effective Exchange Rate Regimes and Inflation," VfS Annual Conference 2021 (Virtual Conference): Climate Economics 242340, Verein für Socialpolitik / German Economic Association.
    • Handle: RePEc:zbw:vfsc21:242340
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    Cited by:

    1. Berrak Bahadir & Neven Valev, 2023. "Global Liquidity and Household Credit Growth," Open Economies Review, Springer, vol. 34(5), pages 1039-1061, November.

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    More about this item

    Keywords

    Exchange rate regimes; Effective exchange rates; Inflation;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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