Monetary discipline and inflation in developing countries: The role of the exchange rate regime

Adherence to a pegged exchange rate regime has the potential to affect inflation in two ways: by instilling monetary discipline and by altering the relationship between money and prices, because shocks to the money stock are absorbed partly by changes in the balance of payments. Although the latter is a disequilibrium phenomenon (if balance of payments deficits are unsustainable in the long run), it might still be important in the medium term. Evidence on the relative importance and magnitude of the two effects is presented, using cross-sectional macroeconomic data from 80 LDCs. Both effects are found to be significant.