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FABSF

WEEKLY LETTER

Number 95-37, November 3, 1995

Is Pegging the Exchange Rate a Cure
for Inflation? East Asian Experiences
A common argument for pegging the nominal
exchange rate is that linking to a stable foreign
currency enforces discipline on domestic monetary policy, thus stabilizing inflation expectations.
In particular, exchange rate pegging can increase
the credibility of a central bank's announced lowinflation goal, by allowing policymakers to import some of the credibility for stable monetary
control associated with foreign policies. For example, pegging the exchange rate contributes
to lower inflation if pressures for domestic currency depreciation are met by tighter monetary
policies.
To varying degrees, East Asian economies (outside japan) have pegged their currencies to the
u.s. dollar. Most have also achieved relatively
low inflation, certainly by the standards of developing countries. Can the relatively successful
performance of East Asian economies be attributed to their exchange rate policies?
This Letter argues that the nominal exchange rate
pegging policies of East Asian economies are not
the explanation for their low inflation. In East Asia,
most currencies have faced pressure to appreciate. Under these circumstances, resistance to
currency appreciation had an expansionary effect
and contributed to higher inflation. Factors other
than pegging, discussed briefly below, appear instead to be responsible for Asia's low inflation.
(For a fuller discussion, see Glick, Hutchison,
and Moreno (GHM) 1995.)

Pegging to the dollar
The exchange rate regimes of East Asian economies have varied widely-for example, Hong
Kong maintains a unilateral peg to the U.s. dollar, Indonesia, Malaysia, Singapore, and Thailand
have fixed or adjustable pegs to a currency basket, and Korea has a managed float.

PACIFIC BASin nOrES

Despite this variety, policymakers in almost all
economies have tended to limit adjustment of
their currencies against the u.s. dollar. Figure 1
illustrates this phenomenon, by means of indices
of monthly nominal bilateral exchange rates
against the u.s. dollar over the period 1985:01 to
1995:04 (for the New Taiwan dollar to 1994:12);
the indices are constructed so that an increase
implies an appreciation of the local currency. The
top panel shows currencies which have on average appreciated against the dollar (including
japan as a reference); the bottom panel shows
currencies that have not appreciated or have
depreciated.
The figure shows that no currency has appreciated as much as the japanese yen and with the

Figure 1
East Asian Dollar Exchange Rates

260
Japan

180

100 .l......k!~~-....=.:-=-:.:.c~~/~r--~
Hong Kong ~

Thailand

;.:;:.: .--

100 ~~,...-...,.,..,..-~----:"~~---,
"':~ ' .'
,

..

-

\

75

Malaysia

\ Philippines ~

Indonesia~ ........... - - - - .....
50

--- ----

+--.--_.___----,-~-.___,_-.--_.___---'-T''=.,-

1985

1987

1989

1991

1993

1995

Note: An increase is an appreciation of the East Asian
currency.

Pacific Basin Notes appears on an occasional
basis. It is prepared under the auspices of the Center for Pacific Basin Monetary and Economic Studies
(CPBMES) within the FRBSF's Economic Research Department.

FRBSF
exceptions of the Singapore dollar and the Indonesian Rupiah, the trends in the exchange rate
appear to be dampened, in the sense that they
have tended to return to their previous levels
against the U.S. dollar or settled on new plateaus.
In all cases (including those of Singapore and
Indonesia) monthly fluctuations in exchange
rates against the dollar appear to be smaller than
in the case of the Japanese yen. The dampened
trends and the relative smoothness of the series
appear to reflect policies designed to stabilize
the value of these currencies against the U.S.
dollar.
Efforts by East Asian countries to stabilize their
currencies against the U.S dollar are also apparent in Frankel and Wei's (1993) finding that over
the period 1979-1992, the weight of the u.s. dollar in estimated currency baskets averaged over
90 percent for East Asian economies, compared
to a 6 percent weight for the yen, and a 3 percent weight for the deutsche mark.

Appreciation versus inflation
In many developing countries, particularly those
experiencing hyperinflation, exchange rate pegging is often an essential part of government
efforts to enhance the credibility of its commitment to disinflation. In East Asia, it is more
likely that pegging reflected efforts to avoid any
adverse effects of currency fluctuations on international trade flows in these highly open economies. In fact, such pegging may have contributed
to inflationary pressures in East Asia after 1985.
To see this, it is worth recalling the distinction
between the nominal exchange rate, which is
the relative price of two currencies, and the real
exchange rate, which is the nominal exchange
rate adjusted for inflation and reflects the price at
which a representative basket of domestic goods
may be exchanged for a representative basket of
foreign goods. A real appreciation means that domestic goods cost more relative to foreign goods.
A nominal appreciation means that a country's
currency costs more relative to foreign currencies.
The equilibrium real exchange rate depends on
relative demands for goods and assets. For example, an event that leads to excess demand for
domestic goods or assets will tend to appreciate
a country's real exchange rate. This equilibrium
real appreciation can occur in two ways. If policymakers allow the nominal exchange rate to
appreciate in response to the excess demandimplying a higher foreign currency price of domestic currency-domestic goods will cost more

relative to foreign goods, resulting in real appreciation. However, if the nominal exchange rate is
pegged, the appreciation in the real exchange
rate will necessarily occur through higher inflation at home than abroad.
After 1985, two factors contributed to pressures
for real exchange rate appreciation in East Asia.
First, between 1985 and 1987, the strong depreciation of the u.S. dollar against major currencies, such as the yen and the deutsche mark,
created a competitive export advantage for economies in the region leading to significant increases
in their trade balances. Second, the decline of
u.S. interest rates between 1989 and 1993 encouraged investors to look for foreign investment
opportunities, spurring capital inflows to East
Asia.
Under these conditions, monetary authorities had
the choice of allowing their nominal exchange
rates to appreciate more freely, or to attempt to
resist pressures for appreciation. However, pegging policies that resisted nominal exchange rate
appreciation contributed to higher inflation. In
particular, those economies whose currencies did
not appreciate freely in response to the depreciation of the dollar experienced an (inflationary)
increase in aggregate demand associated with
more competitive exchange rates. As discussed
by GHM, inflationary pressures also arose from
balance of payments surpluses associated with
increased capital inflows or greater trade surpluses. Reflecting efforts to peg the exchange rate
through intervention, the balance of payment surpluses put upward pressures on money supplies,
contributing to higher inflation.
The phenomenon that more limited nominal
exchange rate appreciation is associated with
higher inflation is illustrated in Figure 2, a scatter diagram relating average annual nominal
exchange rate appreciation against the u.s. (horizontal axis) and domestic consumer price inflation relative to United States inflation (vertical
axis) over the period 1985-1994. Figure 2 shows
that in countries where the nominal exchange
rate did not appreciate against the dollar, domestic inflation tended to exceed u.s. inflation. In
contrast, countries that allowed some nominal
appreciation experienced smaller inflation or
greater price declines relative to the United
States.
The tradeoff between adjustment through nominal exchange rate appreciation or through higher
relative inflation is illustrated by the cases of Hong
Kong and Singapore. Hong Kong's exchange rate
has been fixed against the dollar and since 1985
it has experienced a cumulative inflation relative
to the U.S. that exceeds 50 percent. In contrast to
Hong Kong, Singapore has allowed its nominal

Figure 2
East Asian Currency Appreciation
and Relative Inflation Rates

domestic financial assets, thus raising the proportion of budget deficits that could be financed
by printing money without inflation, as well as
the overall level of government borrowing that
was willingly financed by domestic and foreign
residents.

60

Philippines

•

Hong Kong

50

40
0

i

30

Indonesia

Korea

•

a:

t

20t
10

I

•

Thailand

•

~

·60

·40

·20

40

•
Taiwan

60

•

Singapore

Doms.tic Currsncv Approciation

Note: Positive values indicate domestic currency appreciation relative to U.s. dollar or higher domestic
CPI inflation relative to U.S. CPI inflation.

exchange rate to appreciate by about 50 percent
against the u.s. dollar, limiting cumulative inflation to 20 percent less than the U.s. over the
1985-1994 period.

Why was Asia's inflation low?
If exchange rate policies did not contribute to
Asia's relatively low inflation rates, what did? In
many economies, there are strong pressures to
print money-with corresponding inflationary effects-in order to offset sluggish output growth
or to finance fiscal deficits. One explanation for
East Asia's low inflation is that these types of
pressures have been far smaller than in other
countries. The average growth of per capita GNP
in this region exceeded 5 percent during 19651990, more than twice that of other regions in
the world (including industrial countries). In addition, budget deficits in East Asian economies
are by and largely sustainable, or easily financed
through conventional means. Budget deficits
have been limited in some cases by imposing
caps on the permissible deficits, insulating the
budget process from political pressures, and
avoiding central bank subsidies to banks or large
state enterprises. Even in those cases where budget deficits were large, inflationary pressures
were limited. Rapid growth and high rates of private saving increased the demand for money and

Another explanation for East Asia's low inflation
is that the costs of such inflation may be high in
comparison to other regions. These economies
are highly open-the ratio of exports plus imports to GNP ranges from a low of about 30
percent for the Philippines and Indonesia to a
high of 260 percent for Singapore. Such dependence on international trade means that high inflation may generate relatively high economic
costs if it results in real exchange rate appreciation and a corresponding loss of international
trade competitiveness. Analysis of the data supports this view, as it reveals that greater openness
in East Asian economies is associated with lower
inflation.

Conclusions
The preceding discussion suggests that the nominal exchange rate pegging policies of East Asian
economies are not the explanation for their low
inflation. On the contrary, since 1985, those
economies whose currencies who have been
most stable in value agair,st the U.S. dollar have
tended to experience higher inflation. Factors
other then pegging, such as rapid growth, sustainable budget deficits, and relative openness
most likely explain their relative success in
achieving low inflation.

Reuven Glick
Vice President

Ramon Moreno
Senior Economist

References
Glick, R., M. Hutchison, and R. Moreno. 1995. "Is
Pegging the Exchange Rate a Cure for Inflation?:
East Asian Experiences:' Working Paper No.
PB95-08, Federal Reserve Bank of San Francisco,
Center for Pacific Basin Countries and Economic
Studies. Forthcoming in R. Sweeney, et aI., eds.,
Exchange Rate Policies for Emerging Market
Economies.
Frankel, J., and S. Wei. 1993. "Yen Bloc or Dollar
Bloc: Exchange Rate Policies of the East Asian
Economies:' In T. Ito and A. Krueger, eds., Macroeconomic Linkage: Savings, Exchange Rates,
and Capital Flows. Chicago: University of Chicago
Press.

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System. Editorial comments may be addressed to the editor
or to the author. Free copies of Federal Reserve publications can be obtained from the Public Information Department, Federal
Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 974-2246, Fax (415) 974-3341. Weekly Letter
texts and other FRBSF publications and data are available on FedWest Online, a public bulletin board service reached by setting
your modem to dial (415) 896-0272.

Research Department

Federal Reserve
Bank of
San Francisco
P.O. Box 7702
San Francisco, CA 94120

P~inted on recycled paper ~ ~.
wIth soybean inks.
~ ~

Index to Recent Issues of fRBSf Weekly Letter

DATE

NUMBER TiTlE

AUTHOR

4/7
4114
4/21
4/28
5/5
5112
5119
5/26
6/9
6/23
7/7
7/28
8/4
8118
9/1
9/8
9/15
9/22
9/29
10/6
10/13
10/20
10/27

95-14
95-15
95-16
95-17
95-18
95-19
95-20
95-21
95-22
95-23
95-24
95-25
95-26
95-27
95-28
95-29
95-30
95-31
95-32
95-33
95-34
95-35
95-36

Glick/Moreno
Huh
Parry
Laderman
Glick/Trehan
judd
Kwan
Schaan/Cogley
Kasa
Rudebusch
Motley
Zimmerman
Mattey/Spiegel
Golub
Cogley/Schaan
Walsh
Kasa
Walsh
Huh
Gabriel
Huh
jaffee/Levon ian
Furlong/Zi mmerman

Responses to Capital Inflows in Malaysia and Thailand
Financial Liberalization and Economic Development
Central Bank Independence and Inflation
Western Banks and Derivatives
Monetary Policy in a Changing Financial Environment
Inflation Goals and Credibility
The Economics of Merging Commercial and Investment Banking
Financial Fragility and the Lender of Last Resort
Understanding Trends in Foreign Exchange Rates
Federal Reserve Policy and the Predictability of Interest Rates
New Measures of Output and Inflation
Rebound in U.s. Banks' Foreign Lending
Is State and Local Competition for Firms Harmful?
Productivity and Labor Costs in Newly Industrializing Countries
Using Consumption to Track Movements in Trend GDP
Unemployment
Gaiatsu
Output-Inflation Tradeoffs and Central Bank Independence
Inflation-Indexed Bonds
California Dreamin': A Rebound in Net Migration?
Interest Rate Smoothing and Inflation, Then and Now
Russian Banking
Consolidation: California Style

The FRBSF Weekly Letter appears on an abbreviated schedule in june, july, August, and December.