The Discipline Effects of Fixed Exchange Rates: Constraint versus Incentive Effects and the Distinction between Hard and Soft Pegs

Abstract

There has been much interest in whether fixed exchange rates can provide a strong source of discipline over domestic monetary and fiscal policies. We argue that previous studies, however, have not paid sufficient attention to the distinction between constraint and incentive effects and that these operate quite differently for hard and soft fixes. Using annual data for 31 emerging and 32 developing countries during 1990–2003, our analysis implies that hard fixes should have much stronger discipline effects on money growth and inflation and our empirical study supports their prediction. Our theoretical analysis suggests that neither hard nor soft fixes are likely to provide strong discipline over fiscal policy and this is confirmed by our empirical analysis as well.

Keywords:

• Hard fixes
• Soft pegs
• discipline effects
• incentive structure
• macroeconomic discipline

JEL CLASSIFICATION:

• E52
• E62

Notes

1. See, for example, the analysis and references in Alesina et al. (1997), Drazen (2000), Willett (1988) and Willett and Keil (2004).

2. See Tavlas et al. (2008), Klein and Shambaugh (2010) and Rose (2010) for recent general reviews and Ghosh et al. (2002) on inflation; De Grauwe and Schnabl (2008); Rogoff et al. (2003); Levy-Yeyati and Sturzenegger (2003); Eichengreen and Leblang (2003) on growth; Kaminsky and Reinhart (1999); Eichengreen and Rose (2000); Husain et al. (2005); Angkinand et al. (2009); Angkinand and Willett (2011) on crises.

3. High income countries are often excluded from such analyses because of their general low inflation rates.

4. Rose (2010) expresses skepticism about the robustness of the results of such studies.

5. An important exception is Bleaney and Francisco (2005), who do distinguish between hard and soft pegs and find that only the former have significant effects on many growth and inflation in a large sample of developing countries. We find similar results for a somewhat different set of countries and time period and also explore effects on fiscal policy. Bleaney and Fielding (2002) distinguish between unilateral and coordinated pegs and find much lower inflation with the latter. Levy-Yeyati and Sturzenegger (2001) distinguish between short duration pegs and those that are held for at least five years and find that only the latter have significant effects on lowering inflation. A few studies such as Edwards (2003) look only at hard fixes, which is perfectly legitimate, but does not give us information on the comparative behaviour of soft pegs. Ghosh et al. (2002) and Jackson and Miles (2008) also present separate results for hard and some types of soft fixes as robustness checks, but do not emphasize these results nor provide any discussion of why we would expect substantial differences in the effects of these different types of regimes.

6. See, for example, Angkinand et al. (2009), Willett (2007) and Fischer (2001).

7. See Willett and Mullen (1982), Rogoff (1985) and Willett (1998).

8. See Willett et al. (2008).

9. See Andrews and Willett (1997), Tornell and Velasco (1998, 2000) and Willett (2000). For a more detailed discussion of the role of capital mobility in the context of macroeconomic discipline mechanisms, see Willett et al. (2008).

10. See Willett et al. (2008) and Killeen et al. (2006).

11. For a substantial discussion of this issue see Klein and Shambaugh (2010).

12. Three of the four cases of changes in exchange rate regimes that Miles considers, for instance, Mexico in 1994–1995, Philippines and Thailand in 1997–1998, switched their regimes as a result of severe currency crises that lead to substantial increases in inflation. Miles notes this problem but for the Asian countries he deletes only 1997, comparing 1994–1996 with 1998–2000. Substantial effects from the crisis were still being felt in 1998, however, thus contaminating his analysis. Another problem with this study is the use of LYS's classifications of exchange rate regimes. These have some severe problems (see Willett et al. 2011). For example, Mexico is classified as having a fixed rate in 1994 (their methodology does not allow the distinction between hard and soft fixes) when it had a crawling band and as having intermediate regimes in 1995 and 1996 when it had gone to a flexible rate.

13. Of course when this is done the remaining category of non-free falling floating rates is associated with much better macroeconomic performance and a critic could argue that this is just a biased way of making floating look better, but we believe that there are solid reasons for limiting our analysis to countries with moderate inflation rates.

14. See Husain et al. (2005) and Rogoff et al. (2003).

15. In cases where the government is too politically weak to effectively control fiscal policy, the incentive issues first discussed become substantially weakened, if not entirely moot. Under such circumstances, the only form of external discipline that would have any chance of working would be the hardest of fixes. Likewise, without fundamental reforms just legislating central bank independence and/or inflation targeting would have little chance of succeeding.

16. There are interesting issues, in circumstances of very high inflation rates, concerning whether using exchange rate regimes as nominal anchors can help bring inflation under control faster, but addressing this type of question requires different types of testing than the standard approaches to testing the long run discipline effects of alternative exchange rate regimes and it is this latter question that we are addressing.

17. Some studies such as Fielding and Bleaney (2000) and Klein and Shambaugh (2010) attempt to distinguish between the narrow effects of discipline in terms of reduced rates of money growth and additional short run credibility effects from changes in inflation given the rate of money growth by including money growth in inflation equations. Because of the potential variability of velocity – which can affect the rate of money growth leading to a particular rate of inflation – and the possibility that monetary authorities attempt to take such changes into account, we treat money growth and inflation as two alternative broad measures of monetary discipline and do not attempt to distinguish credibility effects. We believe that the latter is better done via detailed studies of particular episodes. Our data for the fiscal balance and the US Treasury bill interest rate were obtained from the International Monetary Fund's International Financial Statistics (IFS). With the exception of the crisis index, all other variables were obtained from the World Bank's World Development Indicators (WDI). Data on terms of trade were obtained from WDI, but augmented where necessary with data from IFS. For more discussions on the crisis index, see Chiu and Willett (2009).

18. Some argue a better measure would be the cyclically adjusted primary fiscal balance; however, this variable was not readily available for the full sample since a number of countries do not report interest payments.

19. For more details on how the adjustment is done, see Dechsakulthorn (2007).

20. For descriptions and evaluations of these alternative classification schemes, see the analysis and references in Willett et al. (2011).

21. This differs from Bleaney and Francisco who include crawling pegs and bands in their soft peg groups. We choose to focus on our analysis on the difference between hard and adjustable pegs since the theoretical considerations related to crawling pegs and bands are less clear-cut.

22. The IMF classification designates three categories of floats, determined in part by staff judgments about how heavily they are managed. It is not clear a priori whether for our purposes the IMF's middle category of floating, labelled “managed floating” would more appropriately be included in our floating group or in our “other” group. Thus as a robustness check we estimate it both ways, including it as a float regime in our “broad float” category and excluding it from our “narrow float” category (which includes only those regimes classified by the IMF as independent floats).

23. It should be noted that while our theoretical sections take a broad view, our empirical study is necessarily narrow in scope, focusing almost exclusively on the differences in the effects of hard and soft pegs on discipline. For example, while capital mobility is presented in the theory section as an important part of the exchange rate regime/discipline story, it is not included as a part of our empirical analysis. Inflation targeting and central bank independence are two more examples of factors which can certainly be expected to matter in studies of this kind, yet which we do not include in the analysis presented herein. Since our purpose in this paper is to emphasize that there is an important difference between the effects of hard and soft pegs, the empirical treatment of the aforementioned factors in the context of exchange rate regimes and discipline has accordingly been set aside for future research.

24. A more recent study by Alfaro (2005), however, does not find a negative effect of openness on inflation when measures of exchange rate regimes are included. She finds that fixed rates are associated with lower inflation, but does not distinguish between hard and soft fixes.

25. We do find some negative and significant effects for trade openness on inflation particularly in emerging markets using various inflation thresholds.

26. Recent example of such proposals includes Hausmann et al. (2000) and Steil and Litan (2006). For a recent set of analyses of the dollarization debate, see Salvatore et al. (2003).