The structure of public debt and the choice of exchange rate regime

Abstract This paper explores the relationship between the denomination of public debt and the choice of exchange rate regime. Three types of debt (nominal, indexed, and foreign) and two regimes (fixed and flexible) are considered. Indexed debt is insulated against unexpected inflation. The real (domestic‐currency) value of foreign debt is subject to valuation effects from real exchange rate shocks. The ‘fear‐of‐floating’ result, that foreign debt makes pegging more attractive, is shown to hold unambiguously only if the peg is fully credible. If the peg lacks credibility, a critical factor is the perceived likelihood of using the ‘escape clause’ of a switch to a float, which raises the costs of pegging. Foreign debt increases the temptation to resort to the escape clause, so when a peg is not fully credible (as is almost always the case in reality), pegging tends to be less attractive than floating in the presence of foreign debt.