Pegs and Pain

36 Pages Posted: 14 Mar 2011

See all articles by Stephanie Schmitt-Grohé

Stephanie Schmitt-Grohé

Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Martín Uribe

Columbia University - Graduate School of Arts and Sciences - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: March 2011

Abstract

This paper quantifies the costs of adhering to a fixed-exchange-rate arrangement, such as a currency union, for emerging economies. To this end it develops a novel dynamic stochastic disequilibrium model of a small open economy with monetary nonneutrality due to downward nominal wage rigidity. In the model, a negative external shock causes persistent unemployment because the fixed exchange rate and downward wage rigidity stand in the way of real depreciation. In these circumstances, optimal exchange-rate policy calls for large devaluations. In a calibrated version of the model, a large contraction, defined as a two-standard-deviation decline in tradable output causes the unemployment rate to rise by more than 20 percentage points under a peg. The required devaluation under the optimal exchange-rate policy is more than 50 percent. The median welfare cost of a currency peg is shown to be enormous, about 10 percent of lifetime consumption. Adhering to a fixed exchange-rate arrangement is found to be more costly when initial fundamentals are characterized by high past wages, large external debt, high country premia, or unfavorable terms of trade.

Keywords: Currency pegs, currency unions, devaluation, disequilibrium model, downward wage rigidity, unemployment

JEL Classification: E3, F33, F41

Suggested Citation

Schmitt-Grohe, Stephanie and Uribe, Martin, Pegs and Pain (March 2011). CEPR Discussion Paper No. DP8275, Available at SSRN: https://ssrn.com/abstract=1782569

Stephanie Schmitt-Grohe (Contact Author)

Centre for Economic Policy Research (CEPR) ( email )

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United Kingdom

National Bureau of Economic Research (NBER)

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Martin Uribe

Columbia University - Graduate School of Arts and Sciences - Department of Economics ( email )

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