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Pegs and Pain

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  • Martin Uribe

    (Columbia University)

  • Stephanie Schmitt-Grohe

    (Columbia University)

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.

Suggested Citation

  • Martin Uribe & Stephanie Schmitt-Grohe, 2012. "Pegs and Pain," 2012 Meeting Papers 303, Society for Economic Dynamics.
  • Handle: RePEc:red:sed012:303
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    File URL: https://economicdynamics.org/meetpapers/2012/paper_303.pdf
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    References listed on IDEAS

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    1. 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.
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    Cited by:

    1. 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, revised Jun 2016.
    2. Markus K. Brunnermeier & Yuliy Sannikov, 2015. "International Credit Flows and Pecuniary Externalities," American Economic Journal: Macroeconomics, American Economic Association, vol. 7(1), pages 297-338, January.
    3. Schmitt-Grohé, Stephanie & Uribe, Martín, 2012. "The Case For Temporary Inflation in the Eurozone," CEPR Discussion Papers 9133, C.E.P.R. Discussion Papers.
    4. Weithing Zhang & Thomas Mertens & Tarek Hassan, 2014. "Currency Manipulation," 2014 Meeting Papers 401, Society for Economic Dynamics.

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