Pegs and Pain

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.