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Labour market reform and the sustainability of exchange rate pegs

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Author Info

  • Castrén, Olli

    ()
    (DG Economics, European Central Bank,)

  • Takalo , Tuomas

    ()
    (Bank of Finland Research)

  • Wood , Geoffrey

    ()
    (Cass Business School, City University)

Abstract

It is commonly thought that an open economy can accommodate output shocks through either exchange rate or real sector adjustments. We formalise this notion by incorporating labour market rigidities into an 'escape clause' model of currency crises. We show that the absence of structural reform 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 labour markets flexible.

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File URL: http://www.suomenpankki.fi/en/julkaisut/tutkimukset/keskustelualoitteet/Documents/0422.pdf
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Bibliographic Info

Paper provided by Bank of Finland in its series Research Discussion Papers with number 22/2004.

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Length: 40 pages
Date of creation: 13 Oct 2004
Date of revision:
Handle: RePEc:hhs:bofrdp:2004_022

Contact details of provider:
Postal: Bank of Finland, P.O. Box 160, FI-00101 Helsinki, Finland
Web page: http://www.suomenpankki.fi/en/
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Keywords: exchange rate policy; labour market flexibility; structural reform;

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References

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  1. Lockwood, B. & Miller, M. & Zhang, L., 1994. "Designing Monetary Policy when Unemployment Persists," Discussion Papers 9408, Exeter University, Department of Economics.
  2. Maurice Obstfeld, 1994. "The Logic of Currency Crises," NBER Working Papers 4640, National Bureau of Economic Research, Inc.
  3. Rudiger Dornbusch, 1984. "External Debt, Budget Deficits and Disequilibrium Exchange Rates," NBER Working Papers 1336, National Bureau of Economic Research, Inc.
  4. de Kock, Gabriel & Grilli, Vittorio, 1993. "Fiscal Policies and the Choice of Exchange Rate Regime," Economic Journal, Royal Economic Society, vol. 103(417), pages 347-58, March.
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  6. Olivier Blanchard & Justin Wolfers, 1999. "The Role of Shocks and Institutions in the Rise of European Unemployment: The Aggregate Evidence," NBER Working Papers 7282, National Bureau of Economic Research, Inc.
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  8. Olli Castren & Tuomas Takalo, 2000. "Capital Market Development, Corporate Governance and the Credibility of Exchange Rate Pegs," Econometric Society World Congress 2000 Contributed Papers 0515, Econometric Society.
  9. Gregor Irwin, 2004. "Currency boards and currency crises," Oxford Economic Papers, Oxford University Press, vol. 56(1), pages 64-87, January.
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  18. Obstfeld, Maurice, 1996. "Models of Currency Crises with Self-fulfilling Features," CEPR Discussion Papers 1315, C.E.P.R. Discussion Papers.
  19. Svensson, Lars E O, 1995. "Optimal Inflation Targets, 'Conservative' Central Banks, and Linear Inflation Contracts," CEPR Discussion Papers 1249, C.E.P.R. Discussion Papers.
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Citations

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Cited by:
  1. Mikko Puhakka, 2005. "Equilibrium dynamics under lump-sum taxation in an exchange economy with skewed endowments," Macroeconomics 0508033, EconWPA.
  2. Ansgar Belke & Bernhard Herz & Lukas Vogel, 2006. "Exchange Rate Regimes and Reforms: A Panel Analysis for the World versus OECD Countries," International Finance, Wiley Blackwell, vol. 9(3), pages 317-342, December.
  3. repec:onb:oenbwp:y::i:129:b:1 is not listed on IDEAS
  4. Antti Suvanto & Juhana Hukkinen, 2005. "Stable price level and changing prices," Macroeconomics 0508034, EconWPA.
  5. Ansgar Belke & Bernhard Herz & Lukas Vogel, 2005. "Structural Reforms and the Exchange Rate Regime A Panel Analysis for the World versus OECD Countries," Diskussionspapiere aus dem Institut für Volkswirtschaftslehre der Universität Hohenheim 263/2005, Department of Economics, University of Hohenheim, Germany.
  6. Leitemo, Kai & Söderström, Ulf, 2004. "Robust Monetary Policy in the New-Keynesian Framework," CEPR Discussion Papers 4805, C.E.P.R. Discussion Papers.
  7. Ansgar Belke & Bernhard Herz & Lukas Vogel, 2006. "Beyond Trade – Is Reform Effort Affected by the Exchange Rate Regime? A Panel Analysis for the World versus OECD Countries," Economie Internationale, CEPII research center, issue 107, pages 29-58.
  8. Ansgar Belke & Bernhard Herz & Lukas Vogel, 2006. "Are Monetary Rules and Reforms Complements or Substitutes? A Panel Analysis for the World versus OECD Countries," Working Papers 129, Oesterreichische Nationalbank (Austrian Central Bank).

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