Unemployment Persistence and the Sustainability of Exchange Rate Pegs
affiliation not provided to SSRN
Hanken School of Economics - Department of Economics; Helsinki Center of Economic Research (HECER)
Cass Business School
Scottish Journal of Political Economy, Vol. 57, Issue 1, pp. 85-102, February 2010
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.
Number of Pages in PDF File: 18
Date posted: December 22, 2009