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Pegs and Pain

  • Schmitt-Grohé, Stephanie
  • Uribe, Martín

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.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 8275.

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Date of creation: Feb 2011
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Handle: RePEc:cpr:ceprdp:8275
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  1. Stockman, Alan C & Tesar, Linda L, 1995. "Tastes and Technology in a Two-Country Model of the Business Cycle: Explaining International Comovements," American Economic Review, American Economic Association, vol. 85(1), pages 168-85, March.
  2. Enrique G. Mendoza & Vivian Z. Yue, 2008. "A Solution to the Disconnect between Country Risk and Business Cycle Theories," NBER Working Papers 13861, National Bureau of Economic Research, Inc.
  3. 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.
  4. Neumeyer, Pablo Andrés & Perri, Fabrizio, 2004. "Business Cycles in Emerging Economies: The Role of Interest Rates," CEPR Discussion Papers 4482, C.E.P.R. Discussion Papers.
  5. Reinhart, Carmen M. & Vegh, Carlos A., 1995. "Nominal interest rates, consumption booms, and lack of credibility: A quantitative examination," Journal of Development Economics, Elsevier, vol. 46(2), pages 357-378, April.
  6. Jonathan D. Ostry & Carmen M. Reinhart, 1992. "Private Saving and Terms of Trade Shocks: Evidence from Developing Countries," IMF Staff Papers, Palgrave Macmillan, vol. 39(3), pages 495-517, September.
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