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Pegs and Pain

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  • Martin Uribe

    (Columbia University)

  • Stephanie Schmitt-Grohe

    (Columbia University)

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    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 dynamic stochastic disequilibrium model of a small open economy with 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 large, between 4 and 10 percent of lifetime consumption. Fixed exchange rate arrangements are 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.

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    Bibliographic Info

    Paper provided by Society for Economic Dynamics in its series 2012 Meeting Papers with number 303.

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    Date of creation: 2012
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    Handle: RePEc:red:sed012:303

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    1. Alan C. Stockman & Linda L. Tesar, 1991. "Tastes and technology in a two-country model of the business cycle: explaining international co-movements," Working Paper 9019, Federal Reserve Bank of Cleveland.
    2. Lane, Philip R. & Milesi-Ferretti, Gian Maria, 2007. "The external wealth of nations mark II: Revised and extended estimates of foreign assets and liabilities, 1970-2004," Journal of International Economics, Elsevier, vol. 73(2), pages 223-250, November.
    3. Reinhart, Carmen & Vegh, Carlos, 1995. "Nominal interest rates, consumption booms, and lack of credibility: A quantitative examination," MPRA Paper 13898, University Library of Munich, Germany.
    4. Martín González Rozada & Pablo Andrés Neumeyer & Alejandra Clemente & Diego Luciano Sasson & Nicholas Trachter, 2004. "The Elasticity of Substitution in Demand for Non-Tradable Goods in Latin America: The Case of Argentina," Research Department Publications 3179, Inter-American Development Bank, Research Department.
    5. Smets, Frank & Wouters, Rafael, 2007. "Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach," CEPR Discussion Papers 6112, C.E.P.R. Discussion Papers.
    6. Alessandro Barattieri & Susanto Basu & Peter Gottschalk, 2010. "Some Evidence on the Importance of Sticky Wages," Boston College Working Papers in Economics 740, Boston College Department of Economics.
    7. Ariel Burstein & Martin Eichenbaum & Sergio Rebelo, 2004. "Large Devaluations and the Real Exchange Rate," RCER Working Papers 513, University of Rochester - Center for Economic Research (RCER).
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    Cited by:
    1. Jordi Galí & Tommaso Monacelli, 2013. "Understanding the Gains from Wage Flexibility: The Exchange Rate Connection," Working Papers 746, Barcelona Graduate School of Economics.
    2. Jordi Galí & Tommaso Monacelli, 2013. "Understanding the gains from wage flexibility: The exchange rate connection," Economics Working Papers 1408, Department of Economics and Business, Universitat Pompeu Fabra.

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