Citation

Discussion Paper Details

Please find the details for DP8275 in an easy to copy and paste format below:

Full Details   |   Bibliographic Reference

Full Details

Title: Pegs and Pain

Author(s): Stephanie Schmitt-Grohé and Martín Uribe

Publication Date: February 2011

Keyword(s): Currency pegs, currency unions, devaluation, disequilibrium model, downward wage rigidity and unemployment

Programme Area(s): International Macroeconomics

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.

For full details and related downloads, please visit: https://cepr.org/active/publications/discussion_papers/dp.php?dpno=8275

Bibliographic Reference

Schmitt-Grohé, S and Uribe, M. 2011. 'Pegs and Pain'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=8275