"The GCC pegs have proved to be successful nominal anchors
, and even if they are adjusted rather than abandoned, this would add uncertainty about future adjustments, and ultimately make the pegs more vulnerable to speculative attacks.
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
. This cocktail resulted in a growing misalignment of key relative prices, especially a real exchange rate (RER) overvaluation and excessively low subsidized public utilities rates such as residential energy and urban transportation, which ended up affecting both the fiscal and external balances.
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.
Masson, Savastono and Sharma (1998), however, noted that since the early 1990s, an increasing number of countries, beginning with the more advanced economies, have adopted an explicit value for inflation as an alternative intermediate target in their effort to address the difficulties that developed with the use of exchange rates and monetary aggregates as the nominal anchors
. This trend is also evident in Latin American countries, hence, Frankel (2003) gives a detailed account of some of these countries that have been successfully implementing inflation targeting since 1999.
Secondly, the existence of the real and nominal anchors
for a whole series of micro and macroeconomic variables is (due) bound to introduce directly (and reciprocally) causalities and conditionings between the two convergence processes.
All of them have established sufficient credibility of their authorities to enable them to pursue autonomous monetary policies with domestic nominal anchors
(typically an inflation target) and floating exchange rates.
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.
Distinctions between different nominal anchors
can be exaggerated.
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.