Unit 7 Macroeconomic policy in the global economy
7.7 Exchange rate regimes and inflation outcomes in the world
There is a considerable diversity in exchange rate (and hence, monetary policy) regimes across the world. A large (and increasing) number of countries have decided to abandon national control over monetary policy, by either fixing or limiting changes in their exchange rate. The discussion of the Fix model provides a hypothesis to account for this trend: fixing the exchange rate helps to stabilize inflation.
We presented strong evidence of individual countries that have either given up their currency (as in the case of our example of Spain) or have (like Senegal) successfully maintained a rigidly fixed exchange rate. These two countries have indeed kept inflation close to the average inflation rate of countries within the same currency block.
Given the diversity of experience, how reliable is this relationship?
Exchange rates and inflation: Across the spectrum of regimes
The continued dominance of the US dollar is explained in this IMF blog post.
Figure 7.16 shows the relationship between the exchange rate and inflation across a large number of countries, spanning all the monetary regimes described in the previous section. It shows that there has indeed been a very strong correlation between the average rate of exchange rate depreciation (\(\delta\), measured here against the US dollar) and the average inflation rate. Using the US as the comparator makes sense because of its dominant role in global financial markets and its use of inflation targeting—with a target rate of 2% (officially adopted in 2012).
Figure 7.16 The correlation between exchange rate depreciation and inflation (2010–2019).
World Bank. 2024. Consumer price index. Official exchange rate (LCU per US$, period average).
Inflation and exchange rate depreciation are closely correlated
Countries with exchange rates fixed against the US dollar
Countries in the ‘greater eurozone’
Countries with high inflation and rapid exchange rate depreciation
The case of Argentina
Where the nominal exchange rate against the dollar is fixed, or tightly controlled, by definition this must mean that the average rate of depreciation, \(\delta\), is close to zero. Figure 7.16 shows that there is indeed a significant cluster of countries with \(\delta\) close to zero, and that, as the theory predicts, these all had average inflation rates close to the US inflation rate.
At the opposite extreme there is also a (smaller) group of countries that have combined rapid depreciation with high inflation: the FlexNIT economies. As noted earlier, for people living in these countries, national control over monetary policy (and the associated flexibility of the exchange rate) has brought with it high and unstable inflation.
This raises the question: would it make sense for such countries to give up their national control over monetary policy, and either fix their exchange rate, or simply abandon their own currency entirely? Does fixing the exchange rate solve the problem of how to keep inflation low and stable?
Figure 7.16 suggests that the answer to this question is yes—it doesn’t tell us that there is a causal relationship, but exchange rate depreciation and inflation are strongly correlated.
Both in a common currency area and when the exchange rate is truly fixed, both theory and data show that inflation does indeed stabilize at rates close to foreign inflation. When, as in the figure, the foreign economy is the United States (a FlexIT economy that has mostly successfully stabilized its own inflation rate at around 2%), then the result is indeed low inflation.
And even when the exchange rate is not actually fixed, Figure 7.16 shows that those countries that kept their nominal exchange rates against the dollar within a relatively narrow band also had relatively low inflation rates.
But should we conclude that the best way to solve an inflation problem is to fix the exchange rate? Not necessarily!
The model of inflation in Sections 4.4 and 4.8 shows that there is a conflict over the claims on output per worker by workers, owners, and foreigners (the cost of imports). This conflict is resolved at the supply-side equilibrium, at the intersection of the WS and PS curves, where there is a particular level of unemployment and real wages. Inflation rises whenever the wage on the WS curve is above that on the PS curve, either due to demand or supply shocks. When the government uses macroeconomic policy to bring down inflation, the trade-off is higher unemployment, as shown in Sections 5.3 and 5.5.
Unless the change in exchange rate regime is tied to the willingness and ability of the government to bear the costs in terms of higher unemployment and possibly a prolonged recession, changing the exchange rate (and monetary policy regime) is unlikely to be successful. On its own, a different exchange rate regime is not a magic bullet, as the following examples show.
Example 1: Two methods of addressing the inflation problem—Spain in the eurozone and the UK outside it
Viewed simply in terms of inflation, Spain’s adoption of the euro, preceded by a period in the ERM in which it held its exchange rate constant against the Deutsche Mark, did indeed coincide with a period in which Spain shifted from being a relatively high inflation country to having an inflation rate close to the ECB’s inflation target.
But this adjustment was costly. Figure 7.10 shows that the real appreciation of Spain versus Germany led to a subsequent prolonged and painful period of adjustment, with low growth and high unemployment for many years.
Avoiding these costs requires that the government uses supply-side policy to reduce equilibrium unemployment in the economy. As shown using the WS–PS model in Unit 2, this can be achieved by an upward shift in the PS curve (for example, tougher anti-monopoly policy) or a downward shift in the WS curve (for example, unions exercising greater bargaining restraint).
The Spanish example is a reminder that even when fixing the exchange rate does eventually fix the inflation problem, the costs to the real economy incurred over many years can be serious.
And the experience of other European economies—notably the UK—suggests that joining the eurozone was not the only way to get inflation under control.
During the late 1980s, the UK briefly adopted an exchange rate regime close to a fixed exchange rate by targeting its exchange rate against the Deutsche Mark within the European Exchange Rate Mechanism (ERM). But, unlike Spain, the UK did not follow the process through. It went into a recession in the early 1990s, and left the ERM, in quite dramatic fashion, in 1992. The pound sterling depreciated sharply, easing the pain of the recession.
Instead of doubling down in a fixed exchange rate regime (and eventually joining the eurozone), the UK shifted to a FlexIT regime. Using an alternative method of committing to bearing the costs of reducing inflation and keeping it low, it granted the Bank of England independence and delegated to it the task of achieving a 2% inflation target from 1997. Thereafter, the UK inflation rate also remained fairly stable around a 2% inflation target (until the Russia–Ukraine war shock in 2022).
A common feature in the experiences of both countries was that controlling inflation was a policy priority. In Spain, this was implemented by membership of the eurozone; in the UK, by an operationally independent central bank pursuing an inflation target. Our second example shows that a fixed exchange rate may also bring inflation down, but, in the absence of a binding institutional constraint (giving up the national currency (Spain); fixing the exchange rate to the euro (Denmark); or making the central bank independent with an inflation target (UK)), it may not do so on a sustained basis.
Example 2: Fixing the exchange rate is not a magic bullet for controlling inflation—Argentina 1991–2001
Our second example provides a strong argument for caution.
By 1991, successive Argentine governments had introduced a total of four new currencies since 1960. By 1991, when the new peso was introduced, the price of a dollar in Argentine currency had increased by a factor of 110 billion compared to the exchange rate in 1960.
Figure 7.1 shows that Argentina had a long history of high and volatile inflation. For roughly ten years, from 1991 to 2001, it attempted to deal with this by fixing its exchange rate against the dollar. A new peso was introduced which traded at exactly 1 peso to the dollar, and the government committed to maintain this parity.
Figure 7.17 Inflation and the nominal exchange rate in Argentina (1991–2001).
Timothy J. Kehoe, Juan Pablo Nicolini, Thomas J. Sargent, ‘A Framework for Studying the Monetary and Fiscal History of Latin America, 1960–2017’. Federal Reserve Bank of Minneapolis. World Economic Outlook (latest inflation); WDI (latest exchange rate).
The peso–dollar exchange rate (1960–1990)
Inflation in Argentina (1960–1990)
The peso–dollar exchange rate (1991–2001)
Inflation in Argentina (1991–2001)
The peso–dollar exchange rate after 2002
Inflation in Argentina after 2002
The real exchange rate
Figure 7.17 shows that, viewed purely in terms of inflation, the fixed exchange rate policy initially appeared to be effective. Inflation fell rapidly. Within a few years, Argentina had an inflation rate close to that of the United States, and thereafter it was for a while actually lower. But, just as in the example of Spain in the eurozone, for as long as the inflation rate remained higher than US inflation, the real exchange rate was steadily appreciating and Argentina’s competitiveness was falling to the point of causing a recession.
To unwind this process would have required inflation lower than US inflation for a sustained period. As the cost of achieving this (through the recession that was required to create a negative bargaining gap) mounted, pressure on the government to abandon the fixed exchange rate (or be voted out of office) increased. Unemployment in Argentina increased from 5.4% in 1991 to 15% in 2000.
- hyperinflation
- Economists usually define hyperinflation as a monthly inflation rate of more than 50%. In such situations, a unit of currency loses more than 99% of its real spending power within a year.
In the end, in 2001, the fixed exchange rate was abandoned. The peso depreciated rapidly, and inflation resumed. By the early 2020s, Argentina was verging on hyperinflation.
The key lesson from this example is that although, even in a high-inflation country like Argentina, fixing the exchange rate can indeed stabilize inflation for a while, the cure only lasts as long as the country’s commitment to the fixed exchange rate. This commitment is tested both by the political support at home for this ‘cure for inflation’ because of the costs it imposes in the form of a recession, and by the behaviour of global financial markets—to which we turn in the next section.
Exercise 7.4 Changing the exchange rate regime
Find an example of a country that changed its exchange rate regime within the past 50 years. (Hint: check emerging economies or countries that joined the European Union.)
- For your chosen country, find data on the exchange rate, inflation, unemployment, and economic growth. Make sure this data covers at least some years before and after the exchange rate regime changed.
- Plot the data in appropriate chart(s), using a vertical line to mark the date (or year) that the exchange rate regime changed. Comment on any similarities and differences from before and after the regime change.
