On the exchange rate as a nominal anchor: The rise and fall of the credibility hypothesis

Abstract

The credibility hypothesis, which was used to support the use of a pegged exchange rate arrangement as a nominal anchor mechanism, is based on restrictive analytical foundations that circumscribe its real world applicability. While all pegged exchange rate arrangements are subject to circumstances that can undermine the sustainability of the peg, exchange rate nominal anchor pegs are especially fragile because such arrangements introduce problems that are endogenous to that particular type of regime. The East Asian crisis is used to demonstrate the fragility of exchange rate nominal anchor pegs, while the case of Australia demonstrates how a floating currency escaped the contagion of the East Asian crisis.