Lesson 5 of 8 · 12 min
Exchange rate targeting and policy in developing economies
Many developing economies peg their currency to a low-inflation currency to 'import' its inflation record, but then domestic interest rates and money supply must bend to defend the peg, and a peg that is not credible invites speculative attack.
In short
- Exchange rate targeting: fix the currency (or keep it in a band) against a major currency and defend it by buying and selling the home currency in the FX market.
- Benefit: the economy imports the inflation experience of the anchor currency's economy.
- If home inflation runs above the anchor's, the currency weakens; the central bank sells FX reserves and buys home currency, which shrinks money supply and raises short-term rates.
- If home inflation runs below, it sells home currency, expanding money and lowering rates.
- Cost: domestic conditions must adapt to the target; rates and money become more volatile. Without credibility, speculators attack and reserves can run out.
- Developing economies also face thin bond and interbank markets, a fast-changing economy, rapid financial innovation, a poor inflation record and weak central bank independence.
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