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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

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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. Bohn, Henning, 1990. "A positive theory of foreign currency debt," Journal of International Economics, Elsevier, vol. 29(3-4), pages 273-292, November.
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  3. 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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  19. Rudger Dornbusch & Ilan Goldfajn & Rodrigo O. Valdés, 1995. "Currency Crises and Collapses," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 26(2), pages 219-294.
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Citations

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Cited by:
  1. Leitemo, Kai & Söderström, Ulf, 2004. "Robust Monetary Policy in the New-Keynesian Framework," CEPR Discussion Papers 4805, C.E.P.R. Discussion Papers.
  2. 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.
  3. 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.
  4. 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.
  5. Antti Suvanto & Juhana Hukkinen, 2005. "Stable price level and changing prices," Macroeconomics 0508034, EconWPA.
  6. repec:onb:oenbwp:y::i:129:b:1 is not listed on IDEAS
  7. 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).
  8. Mikko Puhakka, 2005. "Equilibrium dynamics under lump-sum taxation in an exchange economy with skewed endowments," Macroeconomics 0508033, EconWPA.

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