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Labour market reform and the sustainability of exchange rate pegs

  • Castrén, Olli

    ()

    (DG Economics, European Central Bank,)

  • Takalo , Tuomas

    ()

    (Bank of Finland Research)

  • Wood , Geoffrey

    ()

    (Cass Business School, City University)

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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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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