Effective Exchange Rate Regimes and Inflation

This paper introduces a new effective exchange rate regime classification. Traditional classifications  define  the  stability  or  flexibility  of  a  currency  with  respect  to  one  (“anchor”) currency,  thus  implicitly  neglecting  information  on  exchange  rate  relationships  against other  currencies.  Our  new  measure  is  computed  as  a  trade-weighted  average  of  bilateral exchange  rate  regimes,  thus  taking  into  account  both  direct  and  indirect  relationships against  all  other  currencies.  We  argue  that  our  “effective”  approach  is  superior  when  it comes to assessing the impact of exchange rate regimes on inflation, because fixing an ex- change rate vis-`a-vis one currency does not completely anchor domestic prices in a world with  multiple  trading  partners.  Using  our  measure  of  effective  exchange  rate  regimes  in a standard empirical analysis of inflation determinants, we find that – compared to freely floating regimes – not only hard pegs, but also narrow and wide soft pegs are associated with significantly lower inflation rates.  This challenges the established view that soft pegs do  not  matter  –  or  are  even  detrimental  –  for  price  stability.   We  find  that  the  effect of  fixing  the  exchange  rate  goes  significantly  beyond  the  “disciplining  effect”  on  money growth,  with  the  inflation  reduction  being  at  least  as  strong  as  the  effect  of  an  official inflation target.