reforms. This is independent from whether distortions in the pegging country are higher or
lower than in the anchor country. The reason why this is the case is the fact that the
government has no longer an influence on the behavior of the central bank. No longer can
the government as a Stackelberg-leader force the central bank into its desired behavior. The
government now takes the rate of inflation as given and instead uses structural reforms to
avoid that output reducing taxation xi will have to be too high. Again, this result can even
obtain if the government imposes its own preferences on the central bank (so that θB = θG )
because d > b/n if n is large.
Thus, in comparison to full monetary union and to monetary autonomy, the unilateral
peg can be reform inducing in pegging countries. In addition, if the pegging country pegs to
an anchor currency that is less inflationary than the home currency, which is the typical
case, distortive taxation will be lower than under the alternative case. Thus, a unilateral peg
will have unambiguously positive effects on output for the pegging country, and this is even
the case when compared with monetary union. A unilateral peg can thus be even "better"
than full membership in a monetary union.12
But what happens if a foreign currency is introduced is chosen instead of a unilateral
peg?13 The difference here would be that there are no seigniorage gains.
Result 3:
Fiscal policy under the adoption of a foreign currency will be more distortive than under
monetary autonomy while structural reform efforts will fall. However, fiscal policy will be
12 Whether increased output is valued sufficiently higher by the government to
actually choose this arrangement depends mainly on the weight that governments assign to
this goal.
13 This is the option of “dollarization” as it is called on the literature, irrespective of
the currency that is unilaterally adopted.
17
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