The Price-Consumption Puzzle of Currency Pegs

21 Pages Posted: 13 Jan 2000

See all articles by Martín Uribe

Martín Uribe

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

Abstract

A defining stylized fact associated with exchange-rate-based stabilization programs is that their initial phase is characterized by several years of continuous expansion in private consumption and a gradual appreciation of the real exchange rate. This paper shows that a large class of standard optimizing models is unable to account for this empirical regularity. In particular, models in this class predict that a gradual appreciation of the real exchange rate must necessarily be accompanied by a declining path of consumption. The paper then suggests several possible solutions to this problem and develops one in detail. Namely, the relaxation of the assumption of time separability in preferences. Specifically, it shows that under habit formation currency pegs induce a positive comovement between consumption and the real exchange rate. The paper also establishes that habit formation provides an explanation for why in failed currency pegs a contraction in aggregate demand sets in before the collapse of the program.

JEL Classification: F31, F32, F41

Suggested Citation

Uribe, Martin, The Price-Consumption Puzzle of Currency Pegs. Available at SSRN: https://ssrn.com/abstract=184968 or http://dx.doi.org/10.2139/ssrn.184968

Martin Uribe (Contact Author)

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

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