Inflation and the Crawling Peg: the Peruvian case
Choy, Ines Marylin
Blanco, Herminio A.
Master of Arts
It is suggested that in cases of frequent changes in the exchange rate, like in the Crawling Peg system, a vicious circle might develop: depreciation of the exchange rate may lead to increased domestic inflationary pressures and further rounds of changes in the exchange rate. This mechanism may be present in the Peruvian economy. A system of Crawling Peg has been adopted and although the deficit in the balance of payments was eliminated, the domestic rate of inflation is still very high. However, in the strict econometric sense, it is difficult to affirm that inflation causes changes in the exchange rate or vice versa because both variables are determined by factors such as the underlying monetary and fiscal policies. In order to examine the relationship between inflation and changes in the exchange rate a model is tested for the Peruvian case. In this model the exchange rate, international reserves and the rate of inflation are jointly determined. Although there is not a direct causality, in the econometric sense, there is a relationship between both variables. As long as the domestic rate of inflation is higher than the world rate of inflation there will be feedback between inflation and changes in the exchange rate.