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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 finance minister of a country experiencing a 15% annual inflation rate makes the following statement: 'To solve our inflation problem, we will peg our currency to the U.S. dollar. Since the U.S. has a stable 2% inflation rate, our country's inflation will also become 2% immediately upon implementing this policy.' Critically evaluate the minister's claim, focusing on the likely effect on the domestic inflation rate and the accuracy of the predicted speed of this change.

Evaluating a Currency Peg Policy

Based on the information provided, compare the likely inflation trends in Country A and Country B over the past decade. Explain the economic principle that accounts for the difference in their price stability.

Inflation Outcomes and Exchange Rate Policies

A country with a history of high and volatile inflation decides to fix its exchange rate to the currency of a large, economically stable partner that consistently maintains a low inflation rate (e.g., 2%). Explain the primary economic mechanism through which this policy is expected to lower the high-inflation country's domestic inflation rate over time.

The Mechanism of Imported Price Stability

Match each exchange rate policy scenario for a small, open economy with its most likely long-term impact on the domestic inflation rate.

A developing nation is experiencing persistent and high domestic inflation, averaging 20% annually. The nation's central bank is considering a new policy to achieve price stability: pegging its currency at a fixed rate to the U.S. dollar, which is backed by an economy with a stable and low inflation rate of around 2%. Based on the relationship between exchange rate regimes and domestic price levels, what is the most likely long-term outcome if this policy is successfully implemented?

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