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Unemployment Persistence and the Sustainability of Exchange Rate Pegs

18 Pages Posted: 22 Dec 2009  

Olli Castrén

affiliation not provided to SSRN

Tuomas Takalo

Bank of Finland, Monetary Policy and Research Department; VATT Institute for Economic Research

Geoffrey Wood

Cass Business School

Date Written: 2009-04-17

Abstract

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

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

Olli Castrén (Contact Author)

affiliation not provided to SSRN

No Address Available

Tuomas Takalo

Bank of Finland, Monetary Policy and Research Department ( email )

P.O. Box 160
Helsinki, FIN-00101
Finland

HOME PAGE: http://https://sites.google.com/site/tuomastakalo/

VATT Institute for Economic Research

Geoffrey Wood

Cass Business School ( email )

London, EC2Y 8HB
Great Britain
+44 0 20 7040 8740 (Phone)
+44 0 20 7040 8881 (Fax)

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