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Pegs and Pain

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  • Stephanie Schmitt-Grohé
  • Martin Uríbe

Abstract

We identify a disconnect between historical and model-based assessments of the costs of currency pegs due to nominal rigidities. While the former attribute major contractions and massive unemployment to currency pegs, the latter find miniscule welfare losses. The goal of this paper is to reconcile these two assessments. We refocus attention to downward wage inflexibility as the central source of nominal rigidity. More importantly, our model departs from existing sticky wage models in the Calvo-Rotemberg tradition in that employment is not always demand determined. This departure creates an endogenous connection between macroeconomic volatility and the average level of unemployment and in this way opens the door to large welfare gains from stabilization policy. In a calibrated version of the model, an external crisis, defined as a two-standard-deviation decline in tradable output and a two-standard-deviation increase in the country interest rate premium, causes the unemployment rate to rise by more than 20 percentage points under a peg. Currency pegs are shown to be highly costly also during regular business-cycle fluctuations. The median welfare cost of a currency peg is 4 and 10 percent of consumption per period.

Suggested Citation

  • Stephanie Schmitt-Grohé & Martin Uríbe, 2011. "Pegs and Pain," NBER Working Papers 16847, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:16847
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    References listed on IDEAS

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    1. 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.
    2. 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.
    3. 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 168-185, March.
    4. Neumeyer, Pablo A. & Perri, Fabrizio, 2005. "Business cycles in emerging economies: the role of interest rates," Journal of Monetary Economics, Elsevier, vol. 52(2), pages 345-380, March.
    5. 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.
    6. 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.
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    Cited by:

    1. Akıncı, Özge, 2013. "Global financial conditions, country spreads and macroeconomic fluctuations in emerging countries," Journal of International Economics, Elsevier, vol. 91(2), pages 358-371.
    2. Luca Fornaro, 2012. "International debt deleveraging," Economics Working Papers 1401, Department of Economics and Business, Universitat Pompeu Fabra, revised Sep 2016.
    3. Fornaro, Luca, 2015. "Financial crises and exchange rate policy," Journal of International Economics, Elsevier, vol. 95(2), pages 202-215.
    4. Benigno, Gianluca & Converse, Nathan & Fornaro, Luca, 2015. "Large capital inflows, sectoral allocation, and economic performance," Journal of International Money and Finance, Elsevier, vol. 55(C), pages 60-87.
    5. Ricardo Reis, 2013. "The Portugese Slump and Crash and the Euro Crisis," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 44(1 (Spring), pages 143-210.
    6. Mandelman, Federico S., 2013. "Monetary and exchange rate policy under remittance fluctuations," Journal of Development Economics, Elsevier, vol. 102(C), pages 128-147.
    7. Zhen Huo & Jose-Victor Rios-Rull, 2013. "Paradox of thrift recessions," Staff Report 490, Federal Reserve Bank of Minneapolis.
    8. Gauti B. Eggertsson & Neil R. Mehrotra & Sanjay R. Singh & Lawrence H. Summers, 2016. "A Contagious Malady? Open Economy Dimensions of Secular Stagnation," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 64(4), pages 581-634, November.
    9. Steven Pennings & Esther Perez Ruiz, 2013. "Fiscal Consolidations and Growth; Does Speed Matter?," IMF Working Papers 13/230, International Monetary Fund.
    10. Anton Korinek & Alp Simsek, 2016. "Liquidity Trap and Excessive Leverage," American Economic Review, American Economic Association, vol. 106(3), pages 699-738, March.
    11. repec:rfe:zbefri:v:35:y:2017:i:1:p:73-95 is not listed on IDEAS

    More about this item

    JEL classification:

    • E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles
    • F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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