Prudential Policy for Peggers

34 Pages Posted: 25 May 2012

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: May 2012

Abstract

This paper shows that in a small open economy model with downward nominal wage rigidity pegging the nominal exchange rate creates a negative pecuniary externality. This peg-induced externality is shown to cause unemployment, overborrowing, and depressed levels of consumption. The paper characterizes the optimal capital control policy and shows that it is prudential in nature. For it restricts capital inflows in good times and subsidizes external borrowing in bad times. Under plausible calibrations of the model, this type of macro prudential policy is shown to lower the average unemployment rate by 10 percentage points, reduce average external debt by more than 50 percent, and increase welfare by over 7 percent of consumption per period.

Keywords: capital controls, currency pegs, downward wage rigidity, pecuniary externality

JEL Classification: E31, E62, F41

Suggested Citation

Schmitt-Grohe, Stephanie and Uribe, Martin, Prudential Policy for Peggers (May 2012). CEPR Discussion Paper No. DP8961, Available at SSRN: https://ssrn.com/abstract=2066334

Stephanie Schmitt-Grohe (Contact Author)

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
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Martin Uribe

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

420 W. 118th Street
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New York, NY 10027
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212-851-4008 (Phone)
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National Bureau of Economic Research (NBER)

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United States

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