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Downward Nominal Wage Rigidity, Currency Pegs, and Involuntary Unemployment

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  • Stephanie Schmitt-Grohé
  • Martín Uribe

Abstract

This paper analyzes the inefficiencies arising from the combination of fixed exchange rates, nominal rigidity, and free capital mobility. We document that nominal wages are downwardly rigid in emerging countries. We develop an open-economy model that incorporates this friction. The model predicts that the combination of a currency peg and free capital mobility creates a negative externality that causes overborrowing during booms and high unemployment during contractions. Optimal capital controls are shown to be prudential. For plausible calibrations, they reduce unemployment by around 5 percentage points. The optimal exchange rate policy eliminates unemployment and calls for large devaluations during crises.

Suggested Citation

  • Stephanie Schmitt-Grohé & Martín Uribe, 2016. "Downward Nominal Wage Rigidity, Currency Pegs, and Involuntary Unemployment," Journal of Political Economy, University of Chicago Press, vol. 124(5), pages 1466-1514.
    • Handle: RePEc:ucp:jpolec:doi:10.1086/688175
    DOI: 10.1086/688175
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