The U.S. dollar serves as a key benchmark for comparing exchange rate depreciation and inflation across countries due to its dominant position in global financial markets and the United States' use of a formal 2% inflation target, which was officially adopted in 2012.

Rationale for Using the US Dollar as a Benchmark in Cross-Country Inflation Analysis

Empirical data from 2009-2019, visualized in Figure 7.16, shows a strong positive correlation between the average rate of a currency's depreciation and its average CPI inflation rate. While this correlation suggests that fixing the exchange rate could be a solution to high inflation, it is important to note that this statistical relationship does not in itself establish a causal link between the two phenomena.

Strong Correlation Between Exchange Rate Depreciation and Inflation (2009-2019)

The scatterplot in Figure 7.16 reveals a distinct group of countries, identified as FlexNIT economies, that simultaneously experience high inflation and rapid currency depreciation. This empirical evidence illustrates a scenario where national control over monetary policy, combined with a flexible exchange rate, has resulted in high and unstable inflation.

FlexNIT Economies as an Empirical Example of High Inflation and Rapid Depreciation

When a country pegs its currency to that of an economy with a history of low and stable inflation, like the United States, it can successfully import that price stability. As predicted by theory and shown in data like Figure 7.16, this policy results in the country's domestic inflation rate converging toward the low rate of the anchor economy (around 2% for the U.S.).

Achieving Low Inflation by Pegging to a Stable Anchor: The US Dollar Example

The data from Figure 7.16 provides evidence that countries maintaining their nominal exchange rates within a narrow range against the U.S. dollar also tended to experience comparatively low inflation rates. This observation extends the findings beyond strictly fixed exchange rate regimes, suggesting that even managed stability can be associated with price stability.

Empirical Link Between Relatively Stable Exchange Rates and Low Inflation

Figure 7.16 is a scatterplot that illustrates the relationship between the average rate of CPI inflation and the average rate of a currency's depreciation against the US dollar for a large sample of countries from 2009 to 2019. The vertical axis, representing inflation, and the horizontal axis, representing depreciation, both range from -5% to 35%. The plot includes a red diagonal line indicating a positive correlation, and a horizontal dashed line at 2% inflation labeled 'US inflation target' as a benchmark.

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The poor inflation performance of countries with flexible exchange rates and no monetary policy anchor, such as FlexNIT economies, raises a critical policy question. It prompts consideration of whether such nations should surrender their monetary autonomy by either fixing their exchange rate to a stable currency or abandoning their national currency altogether. The central issue is whether adopting a fixed-rate system is a dependable strategy for achieving and maintaining low, stable inflation.

Policy Dilemma for High-Inflation Economies: Fix the Exchange Rate or Abandon the Currency?

To cite the ebook, use The CORE Econ Team 2023 The Economy 2.0: Macroeconomics Open access e-text https://core-econ.org/the-economy/.

To cite a unit, use The CORE Econ Team 2023 The Economy 2.0: Macroeconomics Open access e-text https://core-econ.org/the-economy/ Unit [unit number] (url).

CORE Econ - The Economy 2.0: Macroeconomics

Figure 7.16: Correlation between Exchange Rate Depreciation and CPI Inflation (2009-2019)

Using a fixed exchange rate can be an effective short-term strategy to lower inflation, but this success is not guaranteed to last and can serve as a cautionary example for policymakers. For inflation control to be sustained, the policy must be supported by a binding institutional constraint that makes it politically or economically costly for the government to abandon its low-inflation commitment. Without such a strong anchoring mechanism, the benefits of a fixed exchange rate are likely to be only temporary.

Necessity of Binding Institutional Constraints for Sustained Inflation Control

Argentina's 1991–2001 currency board represented a significant departure from its history of monetary financing. By fixing the exchange rate to the US dollar, creating new money to fund deficits became impossible, as it would have caused a depreciation and broken the peg. This policy, along with limited international borrowing capacity, compelled the government to enforce fiscal discipline, which eliminated its primary deficit and led to a surplus. However, the policy's long-term viability was undermined by a growing loss of competitiveness from real appreciation, as Argentine inflation remained above U.S. levels. This led to a severe recession and high unemployment, which, combined with a loss of credibility in financial markets, ultimately caused the policy's abandonment.

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