Pegs are key nominal anchors
against inflation, are backed by huge reserves and receive strong political commitment, and the private sector has no experience of exchange rate volatility.
This strategy was jointly implemented with a monetary policy that implied highly negative real interest rates and used the exchange rate and public utility rates as the main nominal anchors
How the central bank does so depends on a choice of one of two possible nominal anchors
determined by a choice of one of two possible instruments.
Many countries that shifted from fixity to flexibility adopted inflation targets as their alternative nominal anchors
To recap, each of the most popular variables that have been proposed as candidates for nominal anchors
is subject to fluctuations that will add an element of unnecessary monetary volatility to a country that has pegged its money to that variable: velocity shocks in the case of M1, supply shocks in the case of inflation targeting, measurement errors in the case of nominal GDP targeting, fluctuations in world gold markets in the case of the gold standard, and fluctuations in the anchor currency in the case of exchange rate pegs.
There are other nominal anchors
that have been used to try to achieve low inflation--the two most commonly used being monetary aggregate targets and an exchange rate that is fixed to the currency of a country that has had a history of low inflation.
All these forms of explicit nominal anchors
can help reduce the time-inconsistency problem, as the success of countries using them in lowering and controlling inflation demonstrates (Mishkin, 1999b).
A number of potential nominal anchors
for monetary strategy can serve as targets.
Many advocates of the use of exchange rates as nominal anchors
for expectations about economic policies have been forced by recent events to retreat somewhat from their advocacy; it would be unfortunate if the pendulum now swung to the other extreme of absolutely freely floating exchange rates.
This paper examines the role of nominal anchors
in inflation stabilization programs in chronic inflation countries.
Income policies and monetary policies are designed as the twin nominal anchors
of the program and are consistent with its growth, inflation and external objectives.
Fifth, inflation targeting will be more likely to succeed if there are no other nominal anchors
or central bank policy objectives that may conflict with actions to attain the inflation target.