18 Pages Posted: 22 Dec 2009
Date Written: 2009-04-17
It is commonly thought that an open economy can accommodate output shocks through either exchange rate or real sector adjustments. We formalize this notion by incorporating unemployment persistence into a two-sided escape clause model of currency crises. We show that unemployment persistence makes a currency peg more fragile and undermines the credibility of the monetary authority in a dynamic setting. The fragility is captured by a devaluation premium in expectations that increases the average inflation rate when the currency peg is more vulnerable to ‘busts’ than ‘booms’. This interaction between macroeconomic and microeconomic rigidities suggests that a policy reform can only be consistent if it renders either exchange rates or the economy more flexible.
Suggested Citation: Suggested Citation
Castrén, Olli and Takalo, Tuomas and Wood, Geoffrey, Unemployment Persistence and the Sustainability of Exchange Rate Pegs (2009-04-17). Scottish Journal of Political Economy, Vol. 57, Issue 1, pp. 85-102, February 2010. Available at SSRN: https://ssrn.com/abstract=1526836 or http://dx.doi.org/10.1111/j.1467-9485.2009.00508.x
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