On the credibility of alternative exchange rate regimes

Most anti-inflation plans have used a nominal exchange rate anchor even though many other variables can serve this role. The conventional wisdom is that an exchange rate anchor imposes more macroeconomic discipline than other anchors, though theory does not yet provide any clear reason why this is so. We explain the link between an exchange rate anchor and discipline with a model that assumes that the public can monitor the nominal exchange rate more easily than it can the other variables. In our model, a Barro-Gordon of incomplete information with imperfect monitoring, we show that serious stabilizers prefer more visible anchors, such as the nominal exchange rate. We also show that in some circumstances serious stabilizers will choose to fix the exchange rate even when fixed exchange rates have some costs, such as diminished capabilities to respond to external shocks. (C) 1997 Elsevier Science B.V.