Exchange rate regimes, inflation and output volatility in developing countries

The median developing country has had significantly higher inflation than the median advanced country since the early 1980s. We present a model in which a developing country may reduce inflationary expectations by pegging its exchange rate to the currency of an advanced country, at the expense of forgoing its ability to compensate for real exchange rate shocks. Different types of pegged exchange rate offer varying degrees of anti-inflation credibility and of exposure to shocks. Tests on a sample of 80 developing countries support the empirical predictions of the model. (C) 2002 Elsevier Science B.V. All rights reserved.