《货币银行学》课程教学资源（文献资料）Exchange-Rate Pegging in Emerging-Market Countries

Exchange-Rate Pegging in Emerging-Market Countries?byFrederic S.MishkinGraduate School of Business, Columbia University,andNationalBureauofEconomicResearchPhone:212-854-3488,Fax:212-316-9219E-mail:fsm3@columbia.eduJune1998I thank Adam Posen, Robert Hodrick, an anonymous referee and participants in the macro lunch atColumbia University for their helpful comments.Any views expressed in this paper are those ofthe author only and not those of Columbia University or the National Bureau of EconomicResearch

Exchange-Rate Pegging in Emerging-Market Countries? by Frederic S. Mishkin Graduate School of Business, Columbia University, and National Bureau of Economic Research Phone: 212-854-3488, Fax: 212-316-9219 E-mail: fsm3@columbia.edu June 1998 I thank Adam Posen, Robert Hodrick, an anonymous referee and participants in the macro lunch at Columbia University for their helpful comments. Any views expressed in this paper are those of the author only and not those of Columbia University or the National Bureau of Economic Research

ABSTRACTThis paperexamines the questionof whether pegging exchange rates is agood strategyforemergingmarket countries. Although pegging the exchange rate provides a nominal anchor for emergingmarket countries that can help them to control inflation, the analysis in this paper does not providesupportfor this strategy for the conduct of monetary policy.First thereare theusual criticisms ofexchange-rate pegging, that it entails the loss of an independent monetary policy, exposes thecountry tothe transmission of shocks from the anchor country, increases the likelihood ofspeculative attacks and potentially weakens the accountability of policymakers to pursue anti-inflationary policies. However, most damaging to the case for exchange-rate pegging in emergingmarket countries is that it can increase financial fragility and make the potential for financial crisesmore likely.Because of the devastating effects on the economy that financial crises can bring,anexchange-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 thegrantingof independence to the central bank and inflation targetingFrederic S. MishkinGraduateSchoolofBusinessUrisHall619ColumbiaUniversityNewYork,NewYork10027andNBERfsm3@columbia.eduIIntroduction

ABSTRACT 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 make the potential for financial crises more likely. 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 inflation targeting. Frederic S. Mishkin Graduate School of Business Uris Hall 619 Columbia University New York, New York 10027 and NBER fsm3@columbia.edu I. Introduction

In recent years, there has been a growing consensus, even in emerging-market countries, thatcontrolling inflation should be the primary or overriding long-term goal of monetary policy.Pastexperience with high inflation in emerging-market countries has not been a happy one, and there is agrowing literature that suggests that high inflation can be an important factor that retards economicgrowth. Although central bankers, as well as the public, in emerging-market countries now putmore emphasis on controlling inflation, there is still the crucial question of how best to do this. Toachieve low inflation, one choice that emerging-market countries have often made is to peg theircurrency to that ofa large, low-inflation country, typically the United States.2 Is this choice a goodone?This paper examines the question of whether pegging its exchange rate is a good strategy foremerging-market countries. The analysis here suggests that the answer is usually no, except inextreme circumstances where a particularly strong form of exchange-rate pegging might be worthpursuing.Indeed, an important point in the analysis of this paper is that pegging the exchange rateis a less viable strategy for emerging-market countries than it is for industrialized countries.After examining rationales for exchange-rate pegging, the paper discusses criticisms ofexchange rate pegging and why it is so dangerous for emerging-market countries.Because the paperargues that exchange-rate pegging is highly problematic for emerging-market countries, it then goeson to explore what other strategies for inflation control might be reasonable alternatives in thesecountries.Thepaperendswith someconcludingremarks.II.'See, for example, Anderson and Gruen (1995), Briault(1995), Bruno (1991), Feldstein (1997),Fischer(1993,1994)andSarel(1996).2In some cases, this strategy involves pegging the exchange rate at a fixed value to that of the othercountry so that its inflation rate will eventually gravitate tothat of the other country,while in othercases it involves a crawling peg or target in which its curency is allowed to depreciate at a steady rateso that its inflation rate can be slightly higher than that of the other country

In recent years, there has been a growing consensus, even in emerging-market countries, that controlling inflation should be the primary or overriding long-term goal of monetary policy. Past experience with high inflation in emerging-market countries has not been a happy one, and there is a growing literature that suggests that high inflation can be an important factor that retards economic growth.1 Although central bankers, as well as the public, in emerging-market countries now put more emphasis on controlling inflation, there is still the crucial question of how best to do this. To achieve low inflation, one choice that emerging-market countries have often made is to peg their currency to that of a large, low-inflation country, typically the United States.2 Is this choice a good one? This paper examines the question of whether pegging its exchange rate is a good strategy for emerging-market countries. The analysis here suggests that the answer is usually no, except in extreme circumstances where a particularly strong form of exchange-rate pegging might be worth pursuing. Indeed, an important point in the analysis of this paper is that pegging the exchange rate is a less viable strategy for emerging-market countries than it is for industrialized countries. After examining rationales for exchange-rate pegging, the paper discusses criticisms of exchange rate pegging and why it is so dangerous for emerging-market countries. Because the paper argues that exchange-rate pegging is highly problematic for emerging-market countries, it then goes on to explore what other strategies for inflation control might be reasonable alternatives in these countries. The paper ends with some concluding remarks. II. 1 See, for example, Anderson and Gruen (1995), Briault(1995), Bruno (1991), Feldstein (1997), Fischer (1993, 1994) and Sarel (1996). 2 In some cases, this strategy involves pegging the exchange rate at a fixed value to that of the other country so that its inflation rate will eventually gravitate to that of the other country, while in other cases it involves a crawling peg or target in which its currency is allowed to depreciate at a steady rate so that its inflation rate can be slightly higher than that of the other country

RationalesforExchange-RatePeggingFixing the value of an emerging-market's currency to that of a sounder currency, which isexactly what an exchange-rate peg involves, provides a nominal anchor for the economy that hasseveral important benefits. First, the nominal anchor of an exchange-rate peg fixes the inflation ratefor internationally traded goods, and thus directly contributes to keeping inflation under control.Second, ifthe exchange-rate peg is credible, it anchors inflation expectations in the emerging-marketcountry to the inflation rate in the anchor country to whose currency it is pegged.The lowerinflation expectations that then result bring the emerging-market country's inflation rate in line withthat of the low-inflation, anchor country relatively quickly.Another way to think of how the nominal anchor of an exchange- rate peg works to lowerinflation expectations and actual inflation is to recognize that if there are no restrictions on capitalmovements, then a serious commitment to an exchange-rate peg means that the emerging-marketcountry has in effect adopted the monetary policy of the anchor country.As long as thecommitment to the peg is credible, the interest rate in the emerging-market country will be equal tothatintheanchor country.Expansion of themoney supplyto obtainlower interest rates in theemerging-market country relative to that of the low-inflation country will only result in a capitaloutflow and loss of international reserves that will cause a subsequent contraction in the moneysupply, leaving both the money supply and interest rates at their original levels.Thus, another wayof seeing why the nominal anchor of an exchange-rate peg lowers inflation expectations and thuskeeps inflation under control in an emerging-market country is that the exchange-rate peg helps theemerging-market country inherit the credibility of the low-inflation, anchor country's monetarypolicy.A further benefit of having an exchange-rate peg as a nominal anchor in an emerging marketcountry is that it helps provide a discipline on policymaking that avoids the so-called time-inconsistency problem described by Kydland and Prescott (1977), Calvo (1978) and Barro andGordon (1983).The time-inconsistency problem arises because there are incentives for apolicymakerto pursue discretionary policy to achieve short-run objectives, such as higher growth

Rationales for Exchange-Rate Pegging Fixing the value of an emerging-market's currency to that of a sounder currency, which is exactly what an exchange-rate peg involves, provides a nominal anchor for the economy that has several important benefits. First, the nominal anchor of an exchange-rate peg fixes the inflation rate for internationally traded goods, and thus directly contributes to keeping inflation under control. Second, if the exchange-rate peg is credible, it anchors inflation expectations in the emerging-market country to the inflation rate in the anchor country to whose currency it is pegged. The lower inflation expectations that then result bring the emerging-market country's inflation rate in line with that of the low-inflation, anchor country relatively quickly. Another way to think of how the nominal anchor of an exchange- rate peg works to lower inflation expectations and actual inflation is to recognize that if there are no restrictions on capital movements, then a serious commitment to an exchange-rate peg means that the emerging-market country has in effect adopted the monetary policy of the anchor country. As long as the commitment to the peg is credible, the interest rate in the emerging-market country will be equal to that in the anchor country. Expansion of the money supply to obtain lower interest rates in the emerging-market country relative to that of the low-inflation country will only result in a capital outflow and loss of international reserves that will cause a subsequent contraction in the money supply, leaving both the money supply and interest rates at their original levels. Thus, another way of seeing why the nominal anchor of an exchange-rate peg lowers inflation expectations and thus keeps inflation under control in an emerging-market country is that the exchange-rate peg helps the emerging-market country inherit the credibility of the low-inflation, anchor country's monetary policy. A further benefit of having an exchange-rate peg as a nominal anchor in an emerging market country is that it helps provide a discipline on policymaking that avoids the so-called time￾inconsistency problem described by Kydland and Prescott (1977), Calvo (1978) and Barro and Gordon (1983). The time-inconsistency problem arises because there are incentives for a policymaker to pursue discretionary policy to achieve short-run objectives, such as higher growth

and employment, even though the result is poor long-run outcomes -- high inflation. Thetime-inconsistency problem can be avoided if policy is bound by a rule that prevents policymakers frompursuing discretionary policy to achieve short-run objectives. Indeed, this is what an exchange ratepeg can do if the commitment to it is strong enough.With a strong commitment to it, the exchangerate peg eliminates discretionary monetary policy and implies an automatic policy rule that forces atightening of monetary policy when there is a tendency for the domestic currency to depreciate or aloosening of policy when there is a tendency for the domestic currency to appreciate.As McCallum(1995)haspointed out, simplybyrecognizingtheproblem thatforward-looking expectations in thewage-and price-setting process creates fora strategy of pursuingexpansionarymonetarypolicy,central banks candecidenottopursueexpansionarypolicywhichleads to inflation. However, even if the central bank recognizes the problem, there still will bepressures on the central bank to pursue overly expansionary monetary policy by the politicians thatcan lead to this outcome, so thatthetime-inconsistency problem remains:the time-inconsistencyproblem is just shiftedbackone step.Thesimplicityand clarityof anexchangeratepegcanhelpreduce pressures on the central bank from the political process because the exchange-rate peg iseasily understood by the public, providing a "maintenance of a sound currency"as an easy-to-understand rallying cry for the central bank.Thus, an exchange-rate peg can help the monetaryauthorities to resist any political pressures to engage in time-inconsistent policies.With all of these advantages of an exchange-rate peg as a strategy for controlling inflation inemerging market countries, it is not surprising that many of these countries have adopted thisstrategy? However, as we will see in the next two sections, there are sufficient dangers in pursuingan exchange-rate peg, that it may produce poor economic outcomes in most emerging marketcountries.3Another potential advantage of an exchange-rate peg is that by providing a more stable value ofthe currency,it might lowerrisk for foreign investors and thus encourage capital inflows which couldstimulate growth. However, as we will see in Section IV, capital inflows may be highly problematic foran emerging market country because they may help encourage a lending boom which eventuallyweakensthe banking sector and helps stimulatea financial crisis

and employment, even though the result is poor long-run outcomes - high inflation. The time￾inconsistency problem can be avoided if policy is bound by a rule that prevents policymakers from pursuing discretionary policy to achieve short-run objectives. Indeed, this is what an exchange rate peg can do if the commitment to it is strong enough. With a strong commitment to it, the exchange rate peg eliminates discretionary monetary policy and implies an automatic policy rule that forces a tightening of monetary policy when there is a tendency for the domestic currency to depreciate or a loosening of policy when there is a tendency for the domestic currency to appreciate. As McCallum (1995) has pointed out, simply by recognizing the problem that forward￾looking expectations in the wage- and price-setting process creates for a strategy of pursuing expansionary monetary policy, central banks can decide not to pursue expansionary policy which leads to inflation. However, even if the central bank recognizes the problem, there still will be pressures on the central bank to pursue overly expansionary monetary policy by the politicians that can lead to this outcome, so that the time-inconsistency problem remains: the time-inconsistency problem is just shifted back one step. The simplicity and clarity of an exchange rate peg can help reduce pressures on the central bank from the political process because the exchange-rate peg is easily understood by the public, providing a "maintenance of a sound currency" as an easy-to￾understand rallying cry for the central bank. Thus, an exchange-rate peg can help the monetary authorities to resist any political pressures to engage in time-inconsistent policies. With all of these advantages of an exchange-rate peg as a strategy for controlling inflation in emerging market countries, it is not surprising that many of these countries have adopted this strategy.3 However, as we will see in the next two sections, there are sufficient dangers in pursuing an exchange-rate peg, that it may produce poor economic outcomes in most emerging market countries. 3Another potential advantage of an exchange-rate peg is that by providing a more stable value of the currency, it might lower risk for foreign investors and thus encourage capital inflows which could stimulate growth. However, as we will see in Section IV, capital inflows may be highly problematic for an emerging market country because they may help encourage a lending boom which eventually weakens the banking sector and helps stimulate a financial crisis

III.GeneralCriticismsofExchangeRate-PeggingThere are several criticisms in the literature that are leveled against exchange-rate pegging inboth developed and emerging market countries which we will examine first.4These include the lossof an independent monetary policy,the transmission of shocks from the anchor country,thelikelihood of speculative attacks and the potential for weakeningtheaccountability of policymakersto pursue anti-inflationary policies.However, there is an additional criticism of exchange-rate pegsin emergingmarketcountries that does not apply to developed countries:the potential in emergingmarket countries for an exchange-rate peg to increase financial fragility and the likelihood of afinancial crisis.It is this last criticism that we will focus on in the next section which suggests thatan exchange-rate peg is a very dangerous strategy for controlling inflation in emerging marketcountries.LossofIndependentMonetaryPolicyOne prominent criticism of adopting an exchange-rate peg to control inflation is that it results in theloss of an independent monetary policyforthe pegging country.Wehave already seen that withopen capital markets, interest rates in the country pegging its exchange rate are closely linked tothose of the anchor country it is tied to, and its money creation is constrained by money growth inthe anchor country. A country that has pegged its currency to that of the anchor country thereforeloses the ability to use monetary policy to respond to domestic shocks that are independent ofthose hitting the anchor country.For example, if there is a decline in domestic demand specific tothe pegging country, say because ofa decline in the domestic government's spending or a decline inthedemand for exports specific to that country,monetary policy cannot respond by loweringinterest rates because these rates are tied to those of the anchor country.The result is that bothoutput and even inflation mayfall below desirable levels,with themonetary authoritiespowerless4An excellent additional discussion of these criticisms is contained inObstfeld and Rogoff (1995)

III. General Criticisms of Exchange Rate-Pegging There are several criticisms in the literature that are leveled against exchange-rate pegging in both developed and emerging market countries which we will examine first.4 These include the loss of an independent monetary policy, the transmission of shocks from the anchor country, the likelihood of speculative attacks and the potential for weakening the accountability of policymakers to pursue anti-inflationary policies. However, there is an additional criticism of exchange-rate pegs in emerging market countries that does not apply to developed countries: the potential in emerging market countries for an exchange-rate peg to increase financial fragility and the likelihood of a financial crisis. It is this last criticism that we will focus on in the next section which suggests that an exchange-rate peg is a very dangerous strategy for controlling inflation in emerging market countries. Loss of Independent Monetary Policy One prominent criticism of adopting an exchange-rate peg to control inflation is that it results in the loss of an independent monetary policy for the pegging country. We have already seen that with open capital markets, interest rates in the country pegging its exchange rate are closely linked to those of the anchor country it is tied to, and its money creation is constrained by money growth in the anchor country. A country that has pegged its currency to that of the anchor country therefore loses the ability to use monetary policy to respond to domestic shocks that are independent of those hitting the anchor country. For example, if there is a decline in domestic demand specific to the pegging country, say because of a decline in the domestic government's spending or a decline in the demand for exports specific to that country, monetary policy cannot respond by lowering interest rates because these rates are tied to those of the anchor country. The result is that both output and even inflation may fall below desirable levels, with the monetary authorities powerless 4An excellent additional discussion of these criticisms is contained in Obstfeld and Rogoff (1995)

to stopthesemovements.This criticism of exchange-rate pegging may be less relevant for emerging market countriesthan it is for developed countries. Because many emerging market countries have not developed thepolitical or monetary institutions which result in the ability to use discretionary monetary policysuccessfully, they may have little to gain from an independent monetary policy but a lot to loseThus,they would be better off by,in effect, adopting the monetary policy of a country like theUnited States through exchange-rate pegging than in pursuing their own independent policy.Transmissionof ShocksfromtheAnchor CountryAnother criticism of exchange-rate pegging is that shocks in the anchor country will be moreeasily transmitted to the pegging country,with possible negative consequences.For example, in1994concernsaboutinflationarypressure in theUnited States ledtheFederal Reserveto implementa series of increases in the federal funds rate.Although this policy was appropriate and highlysuccessful forthe United States, the consequences for Mexico, who had adopted a peg to the dollaras part of its stabilization strategy, were severe.The doubling in short-term U.S.rates from aroundthreeto sixpercentwas transmitted immediatelyto Mexicowhofound its short-termratesdoublingfrom around ten to twenty percent.This rise in rates was damaging to the balance sheets of bothhouseholds, nonfinancial business and the banks, and was a factor in provoking the foreign exchangeand financial crisis in Mexico which began in December 1994.(See Mishkin, 1996.)SpeculativeAttacksA further criticism of exchange-rate pegging is that, as emphasized in Obstfeld and Rogoff(1995), it leaves countries open to speculative attacks on their currencies. As we have seen inEurope in 1992, Mexico in 1994 and more recently in southeast Asia, it is certainly feasible forgovernments to maintain their exchange ratepegby raising interest rates sharply,but theydo notalways have the will to do so. Defending the exchange rate by raising interest rates can be verycostly because it involves having to tolerate the resulting rise in unemployment and damage to the

to stop these movements. This criticism of exchange-rate pegging may be less relevant for emerging market countries than it is for developed countries. Because many emerging market countries have not developed the political or monetary institutions which result in the ability to use discretionary monetary policy successfully, they may have little to gain from an independent monetary policy but a lot to lose. Thus, they would be better off by, in effect, adopting the monetary policy of a country like the United States through exchange-rate pegging than in pursuing their own independent policy. Transmission of Shocks from the Anchor Country Another criticism of exchange-rate pegging is that shocks in the anchor country will be more easily transmitted to the pegging country, with possible negative consequences. For example, in 1994 concerns about inflationary pressure in the United States led the Federal Reserve to implement a series of increases in the federal funds rate. Although this policy was appropriate and highly successful for the United States, the consequences for Mexico, who had adopted a peg to the dollar as part of its stabilization strategy, were severe. The doubling in short-term U.S. rates from around three to six percent was transmitted immediately to Mexico who found its short-term rates doubling from around ten to twenty percent. This rise in rates was damaging to the balance sheets of both households, nonfinancial business and the banks, and was a factor in provoking the foreign exchange and financial crisis in Mexico which began in December 1994. (See Mishkin, 1996.) Speculative Attacks A further criticism of exchange-rate pegging is that, as emphasized in Obstfeld and Rogoff (1995), it leaves countries open to speculative attacks on their currencies. As we have seen in Europe in 1992, Mexico in 1994 and more recently in southeast Asia, it is certainly feasible for governments to maintain their exchange rate peg by raising interest rates sharply, but they do not always have the will to do so. Defending the exchange rate by raising interest rates can be very costly because it involves having to tolerate the resulting rise in unemployment and damage to the

balance sheets of financial institutions from these high rates.Once speculators begin to questionwhether the government's commitment to the exchange-rate peg is strong because of the now highcosts to maintain it, they are in effect presented with a one-way bet, where the only way for thevalue of the currency togo is down.Defenseofthe currency nowrequires massive intervention andevenhigherdomestic interestrates.With all but the strongest commitment to the exchange-rate peg, a government will be forcedto devalue its currency. The attempted defense of the currency will not come cheaply because ofthe losses sustained as a result of the previous exchange-market intervention,For example, in thecaseoftheSeptember1992crisis,theBritish,French,Italian,SpanishandSwedishcentralbankshad intervened to the tune of an estimated s10o billion. Reports in the press estimated that thesecentral banks lost $4 to $6 billion as a result of their exchange-rate intervention in the crisis, anamount that was in effect paid by taxpayers in these countries. Although the losses suffered bycentral banks in emerging market countries after an unsuccessful defense of the currency areharderto estimate, they are likelyto havebeen very substantial.WeakenedAccountabilityIn the United States, the long-term bond market provides signals that make overlyexpansionary monetarypolicyless likely.If theFederal Reserve pursues overly expansionarymonetary policy or politicians put a lot of pressure on the Fed to do so, the bond market is likely toundergo an inflation scare of the type described in Goodfriend (1993) in which long-tem bondprices sink dramatically and long-term rates spike upwards.Concerns about inflation scares in thelong-bond market help keep the Fed from pursuing expansionary policy actions to meet short-runemployment objectives, which ameliorates the time-inconsistency problem. Thus, the signals fromthe long-bond market make the Federal Reserve more accountable for keeping inflation undercontrol.Similarly,politiciansaremorereluctantto criticize Federal Reserve anti-inflation actionsbecause of their fears of what the long-bond market's reaction will be. The long-bond market thusnot only produces signals which help diminish the time-inconsistency problem by making thecentral bank more accountable, but also by reducing political pressure for overly expansionary

balance sheets of financial institutions from these high rates. Once speculators begin to question whether the government's commitment to the exchange-rate peg is strong because of the now high costs to maintain it, they are in effect presented with a one-way bet, where the only way for the value of the currency to go is down. Defense of the currency now requires massive intervention and even higher domestic interest rates. With all but the strongest commitment to the exchange-rate peg, a government will be forced to devalue its currency. The attempted defense of the currency will not come cheaply because of the losses sustained as a result of the previous exchange-market intervention. For example, in the case of the September 1992 crisis, the British, French, Italian, Spanish and Swedish central banks had intervened to the tune of an estimated $100 billion. Reports in the press estimated that these central banks lost $4 to $6 billion as a result of their exchange-rate intervention in the crisis, an amount that was in effect paid by taxpayers in these countries. Although the losses suffered by central banks in emerging market countries after an unsuccessful defense of the currency are harder to estimate, they are likely to have been very substantial. Weakened Accountability In the United States, the long-term bond market provides signals that make overly expansionary monetary policy less likely. If the Federal Reserve pursues overly expansionary monetary policy or politicians put a lot of pressure on the Fed to do so, the bond market is likely to undergo an inflation scare of the type described in Goodfriend (1993) in which long-term bond prices sink dramatically and long-term rates spike upwards. Concerns about inflation scares in the long-bond market help keep the Fed from pursuing expansionary policy actions to meet short-run employment objectives, which ameliorates the time-inconsistency problem. Thus, the signals from the long-bond market make the Federal Reserve more accountable for keeping inflation under control. Similarly, politicians are more reluctant to criticize Federal Reserve anti-inflation actions because of their fears of what the long-bond market's reaction will be. The long-bond market thus not only produces signals which help diminish the time-inconsistency problem by making the central bank more accountable, but also by reducing political pressure for overly expansionary

monetarypolicyto increase employment in the short-termIn many countries, particularly emerging market countries, the long-term bond market isessentiallynonexistent.Inthesecountries,however,theforeignexchangemarketcanplayasimilarrole to the long-bond market in constraining policy from being too expansionary.In the absence ofan exchange rate peg, daily fluctuations in the exchange rate provide information on the stance ofmonetary policy, thus making monetary policymakers more accountable. A depreciation of theexchange rate can provide an early warning signal to the public and policymakers that monetarypolicy is overly expansionary.Furthermore, just as the fear of a visible inflation scare in the bondmarket that causes bond prices to decline sharply constrains politicians from encouraging overlyexpansionary monetary policy, fear of immediate exchange rate depreciations can constrainpoliticians in countries without long-term bond markets from supporting overly expansionarypolicies.An important disadvantage of an exchange rate peg is that it removes the signal that theforeign exchangemarket provides about the stanceof monetary policy on a daily basis.Underapegged exchange-rate regime, central banks often pursue overly expansionary policies that are notdiscovered until too late, when a successful speculative attack has gotten underway.The problemof lack of accountability ofthe central bank under a pegged exchange-rate regime is particularly acutein emerging market countries where the balance sheets of the central banks are not as transparent asin developed countries, thus making it harder to ascertain the central bank's policy actions.Although, an exchange-rate peg appears to provide rules for central bank behavior that eliminates thetime-inconsistency problem, it can actually make the time-inconsistency problem more severebecause it may actually make central bank actions less transparent and less accountableIV.WhyExchangeRatePegging is SoDangerousfor Emerging Market CountriesThe potential dangers from an exchange-rate peg described above apply to both developed

monetary policy to increase employment in the short-term. In many countries, particularly emerging market countries, the long-term bond market is essentially nonexistent. In these countries, however, the foreign exchange market can play a similar role to the long-bond market in constraining policy from being too expansionary. In the absence of an exchange rate peg, daily fluctuations in the exchange rate provide information on the stance of monetary policy, thus making monetary policymakers more accountable. A depreciation of the exchange rate can provide an early warning signal to the public and policymakers that monetary policy is overly expansionary. Furthermore, just as the fear of a visible inflation scare in the bond market that causes bond prices to decline sharply constrains politicians from encouraging overly expansionary monetary policy, fear of immediate exchange rate depreciations can constrain politicians in countries without long-term bond markets from supporting overly expansionary policies. An important disadvantage of an exchange rate peg is that it removes the signal that the foreign exchange market provides about the stance of monetary policy on a daily basis. Under a pegged exchange-rate regime, central banks often pursue overly expansionary policies that are not discovered until too late, when a successful speculative attack has gotten underway. The problem of lack of accountability of the central bank under a pegged exchange-rate regime is particularly acute in emerging market countries where the balance sheets of the central banks are not as transparent as in developed countries, thus making it harder to ascertain the central bank's policy actions. Although, an exchange-rate peg appears to provide rules for central bank behavior that eliminates the time-inconsistency problem, it can actually make the time-inconsistency problem more severe because it may actually make central bank actions less transparent and less accountable. IV. Why Exchange Rate Pegging is So Dangerous for Emerging Market Countries The potential dangers from an exchange-rate peg described above apply to both developed

and emerging market countries and are indeed serious ones.On these grounds alone, using anexchange-rate peg to control inflation is problematic.However, there is an additional danger thatarises for emerging market countries from an exchange-rate peg that does not apply to developedcountries: the potential for an exchange-rate peg to promote financial fragility and possibly a full-fledged financial crisis. Indeed, this additional danger is so severe that it suggests that emergingmarket countries would be well advised to avoid an exchange-rate peg except in very rarecircumstances.Emerging market countries have a very different institutional structure in their credit marketsthan in developed countries. Industrialized countries typically have long duration debt almost all ofwhich is denominated in the domestic currency and also have a fair degree of credibility that theywill not allow inflation to spin out of control. On the other hand, the institutional features of creditmarkets in emerging market countries are diametrically opposite. Because of past experience withhigh and variable inflation rates these countries have little inflation-fighting credibility and debtcontracts are therefore of very short duration and are often denominated in foreign currencies.Aswe shall see, this structure of debt markets in emerging market countries means that an exchange-ratepeg can make itmore likely thatthey willexperiencefinancial crises,whichhavedisastrouseffectsontheireconomies.To see why exchange-rate pegs in an emerging market country make a financial crisis morelikely, we must first understand what a financial crisis is and why it is so damaging to the economyIn recent years, an asymmetric information theory of financial crises has been developed whichprovides a definition of a financial crisis [Bernanke (1983), Calomiris and Gorton (1991), andMishkin (1991, 1994 and 1996).] A financial crisis is a nonlinear disruption to financial markets inwhichasymmetric information problems(adverse selectionandmoral hazard)becomemuch worse,so thatfinancial markets are unable to efficiently channel funds to economic agents who have themost productive investment opportunities.A financial crisis thus prevents the efficient functioningoffinancial markets,whichtherefore leadstoasharpcontraction in economicactivity.With a pegged exchange-rate regime, depreciation of the currency when it occurs is a highlynonlinear event because it involves a devaluation.In most developed countries a devaluation haslittle direct effect on the balance sheets of households, firms and banks because their debts are

and emerging market countries and are indeed serious ones. On these grounds alone, using an exchange-rate peg to control inflation is problematic. However, there is an additional danger that arises for emerging market countries from an exchange-rate peg that does not apply to developed countries: the potential for an exchange-rate peg to promote financial fragility and possibly a full￾fledged financial crisis. Indeed, this additional danger is so severe that it suggests that emerging market countries would be well advised to avoid an exchange-rate peg except in very rare circumstances. Emerging market countries have a very different institutional structure in their credit markets than in developed countries. Industrialized countries typically have long duration debt almost all of which is denominated in the domestic currency and also have a fair degree of credibility that they will not allow inflation to spin out of control. On the other hand, the institutional features of credit markets in emerging market countries are diametrically opposite. Because of past experience with high and variable inflation rates these countries have little inflation-fighting credibility and debt contracts are therefore of very short duration and are often denominated in foreign currencies. As we shall see, this structure of debt markets in emerging market countries means that an exchange-rate peg can make it more likely that they will experience financial crises, which have disastrous effects on their economies. To see why exchange-rate pegs in an emerging market country make a financial crisis more likely, we must first understand what a financial crisis is and why it is so damaging to the economy. In recent years, an asymmetric information theory of financial crises has been developed which provides a definition of a financial crisis [Bernanke (1983), Calomiris and Gorton (1991), and Mishkin (1991, 1994 and 1996).] A financial crisis is a nonlinear disruption to financial markets in which asymmetric information problems (adverse selection and moral hazard) become much worse, so that financial markets are unable to efficiently channel funds to economic agents who have the most productive investment opportunities. A financial crisis thus prevents the efficient functioning of financial markets, which therefore leads to a sharp contraction in economic activity. With a pegged exchange-rate regime, depreciation of the currency when it occurs is a highly nonlinear event because it involves a devaluation. In most developed countries a devaluation has little direct effect on the balance sheets of households, firms and banks because their debts are