THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 572

540

PA R T V I

International Finance and Monetary Policy
such increases put a strain on the international financial system and may stimulate
world inflation, the Fed worries about U.S. balance-of-payments and current
account deficits. To help shrink these deficits, the Fed might pursue a more contractionary monetary policy.

Exchange Rate Unlike balance-of-payments considerations, which have become less important
Considerations under the current managed float system, exchange rate considerations now play a
greater role in the conduct of monetary policy. If a central bank does not want to
see its currency fall in value, it may pursue a more contractionary monetary policy of reducing the money supply to raise the domestic interest rate, thereby
strengthening its currency. Similarly, if a country experiences an appreciation in its
currency, domestic industry may suffer from increased foreign competition and
may pressure the central bank to pursue a higher rate of money growth in order
to lower the exchange rate.

TO PE G O R NOT TO P EG : E XCHA NG E -RAT E TARGE T IN G AS
AN ALTE RN ATI VE M O NE TARY P O LI CY STRAT EG Y
In Chapter 18, we discussed several monetary policy strategies that could be
followed to promote price stability, including monetary targeting and inflation targeting. One other strategy also uses a strong nominal anchor to promote price
stability: exchange-rate targeting (sometimes referred to as an exchange-rate peg).
Targeting the exchange rate is a monetary policy strategy with a long history.
It can take the form of fixing the value of the domestic currency to a commodity
such as gold, the key feature of the gold standard described earlier in the chapter.
More recently, fixed exchange-rate regimes have involved fixing the value of the
domestic currency to that of a large, low-inflation country like the United States or
Germany (the anchor country). Another alternative is to adopt a crawling target
or peg, in which a currency is allowed to depreciate at a steady rate so that the
inflation rate in the pegging country can be higher than that of the anchor country.

Advantages of
Exchange-Rate
Targeting

Exchange-rate targeting has several advantages. First, the nominal anchor of an
exchange-rate target directly contributes to keeping inflation under control by
tying the inflation rate for internationally traded goods to that found in the anchor
country. It does this because the foreign price of internationally traded goods is
set by the world market, while the domestic price of these goods is fixed by the
exchange-rate target. For example, until 2002 in Argentina the exchange rate for
the Argentine peso was exactly one to the U.S. dollar, so that a bushel of wheat
traded internationally at five U.S. dollars had its price set at five pesos. If the
exchange-rate target is credible (i.e., expected to be adhered to), the exchangerate target has the added benefit of anchoring inflation expectations to the inflation rate in the anchor country.
Second, an exchange-rate target provides an automatic rule for the conduct
of monetary policy that helps mitigate the time-inconsistency problem
described in the Web Appendix to Chapter 15. As we saw earlier, an exchangerate target forces a tightening of monetary policy when there is a tendency for
the domestic currency to depreciate or a loosening of policy when there is a
tendency for the domestic currency to appreciate, so that discretionary monetary policy is less of an option. The central bank will therefore be constrained
from falling into the time-inconsistency trap of trying to expand output and
employment in the short run by pursuing overly expansionary monetary policy.