Is A Peg Exchange Rate Regime Is The Loss Of Control Over Monetary Policy?

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One prominent criticism of adopting a peg exchange rate regime is the loss of control over monetary policy. The simultaneous combination of a fixed exchange rate regime and open capital markets with an independent monetary policy constitutes the Impossible Trinity. If the exchange rate is pegged and capital is mobile, then the domestic nominal interest rate must equal the foreign nominal interest rate. Lack of effective local monetary policy is harmful, especially when a country is hit by domestic shocks which are not correlated with business cycles in the anchor country. A domestic monetary policy is a plus, but the existence of an independent monetary policy does not guarantee its proper performance. Developing countries usually do…show more content…
Three historical examples of the Bretton Woods system in the 1970s, the successful attacks under the European Monetary System in 1992 and 1993 and the emerging market crises of 1994-2000 prove that the fragility of a peg exchange rate is more severe under an open capital market (Obstfeld and Rogoff, 1995). Another challenge in a fixed exchange rate regime, after choosing the right anchor, is pegging to the right rate. The risk of being locked into a misaligned exchange rate is a disadvantage of a fixed exchange rate regime. The equilibrium exchange rate -- an exchange rate based on the fundamentals -- is the efficient rate. Any divergence from this rate and insisting on the wrong exchange rate is damaging. This is not the case in a floating exchange rate regime where the exchange rate is not locked. However, even in a floating exchange rate regime, there is a possibility of being far from the equilibrium exchange rate for some time. In a fixed exchange rate regime, especially if the trade of a country is concentrated with those major currencies, the cross-rate fluctuation (the fluctuations of the anchor currency against other major currencies) is another severe flaw. For example, the Persian Gulf oil exporting countries follow a peg exchange rate to the US dollar and have most of their trade with Europe and Japan. In 1997, the appreciation of the US dollar

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