IMPORTING CREDIBILITY THROUGH EXCHANGE-RATE PEGGING

This paper employs an optimal taxation framework in order to study the credibility of monetary policy-making in an open economy. Since infla tion is, in part, uncontrollable due to stochastic disturbances, the a uthority's actions cannot be monitored perfectly when the exchange rat e floats, thus implying that reputational forces may become ineffectiv e. In contrast, pegging the nominal exchange rate to a low-inflation c urrency allows perfect monitoring, because the exchange rate is, in pr inciple, controllable. For this reason, exchange rate pegging may impo rt credibility and result in the best reputational equilibrium, even t hough the authority retains the discretion to devalue unexpectedly.