Issues of fixed versus floating exchange rates are addressed by an extensive literature and are not as black and white as frequently implied. This paper deals with implications of exchange regime choices for inflation, focusing on two issues: the operational distinctions between regimes and the empirical evidence. The usefulness of a market-driven exchange rate as a monetary indicator is clear when structural changes limit the usefulness of monetary aggregates, or when observations on real interest rate and yield curves are blurred, owing to inflation or insufficient depth of domestic financial markets. The paper concludes that, because the exchange rate can be such a useful indicator, even fixed rate regimes should normally allow short-run market flexibility, within relatively wide margins. Fixed-rate regimes should also allow sufficient medium-term flexibility to deal with shocks that are not reversible.
Recent cross-country experience with fixed and market-driven exchange rate regimes is examined in the paper. Evidence is presented that in industrial countries, inflation has tended to lead exchange rate volatility (which declined on an annual basis in the 1980s). A survey of the recent empirical literature suggests a mixed record in the attempts to associate exchange regimes with inflation. One-shot, anchor-type adjustments of the Bretton Woods variety appear to have had little success in stabilization, except when inflation was initially low. However, this empirical outcome might have been attributable to the incompleteness of the traditional adjustments, owing to uncertainty about the equilibrium rate level and related monetary and fiscal policy shortcomings. Very recent, but as yet inconclusive, evidence on strict rule-based monetary and exchange rate policies under the currency-board approach has been more positive. Other anchor-type adjustments have often been preceded by considerable exchange rate flexibility, which re-established international reserves, or have been followed by flexibility, so that their characterization as an anchor is questionable.
Independently floating regimes, a relatively new but by now widespread phenomenon in developing countries, have been demonstrably successful in the available studies. Such regimes have almost always been adopted in the context of comprehensive programs of stabilization and liberalization, and most have been aimed at addressing the effects of the debt crisis. However, the overall conclusion of the paper is that there is no automatic linkage between exchange regime choice and inflation. Whether additional credibility could be gained by anchoring both the exchange rate and monetary policies depends on whether the two sets of responsibilities are vested in more than one institution--central bank, ministry of finance, or regional, multilateral institutions. Usually, responsibilities are not effectively split this way in developing countries. Moreover, the important issue is how the responsibilities are actually discharged and the track record that is established.