Unemployment Persistence and the Sustainability of Exchange Rate Pegs
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.
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