The Effect of Fixed Exchange Rates on Monetary Policy

Abstract

To investigate how a fixed exchange rate affects monetary policy, this paper classifies countries as pegged or non-pegged and examines whether a pegged country must follow the interest rate changes in the base country. Despite recent research which hints that all countries, not just pegged countries, lack monetary freedom, the evidence shows that pegs follow base country interest rates more than non-pegs. This study uses actual behavior, not declared status, for regime classification; expands the sample including base currencies other than the dollar; examines the impact of capital controls, as well as other control variables; considers the time series properties of the data carefully; and uses cointegration and other levels-relationship analysis to provide additional insights.

Openness, exchange rate regimes and the Phillips curve

“…In the polar case of a completely …xed exchange rate and full capital mobility domestic monetary policy must always be set in line with foreign monetary policy, see Shambaugh (2004) for some supporting evidence. If policy were not to be set in this way an interest rate di¤erential would emerge between the home economy and the rest of the world and the …xed exchange rate would be untenable.…”

“…The exchange rate regime classi…cation due to Shambaugh (2004) is also considered in some of the regression estimates in order to check the robustness of the basic results. This is a 0 1 de facto classi…cation that uses di¤erent criteria in assessing actual exchange rate behaviour and does not look at parallel market data.…”

New Measures of the Trilemma Hypothesis: Implications for Asia

“…The pursuit of more nuanced approaches, however, comes at the expense of a smaller coverage of countries. As Appendix 1 reports, the country list, for which we have the 2 The base country is defined as the country that a home country's monetary policy is most closely linked with as in Shambaugh (2004); it is either Australia, Belgium, France, Germany, India, Malaysia, South Africa, the United Kingdom, or the US. More details on the construction of the indexes can be found in Aizenman, Chinn, and Ito.…”

“…The exchange rate is between the home currency and the currency of the base country (as defined in Shambaugh 2004). The changes in the nominal interest rate and foreign exchange reserves are included as the differentials from those of the "base country."…”

“…The changes in the nominal interest rate and foreign exchange reserves are included as the differentials from those of the "base country." For the countries whose base countries are not defined by Shambaugh (2004), we follow the definition made by Aizenman, Chinn and Ito (2008). The weights are inversely related to the variance of changes in each component for each of the sample countries.…”