Currency Pegs and Unemployment
This draft: August 3, 2010Preliminary and incomplete
Countries can ﬁnd themselves conﬁned to a currency peg in a number of ways. For instance,a country could have adopted a currency peg as a way to stop high or hyperinﬂation ina fast and nontraumatic way. A classical example is the Argentine Convertibility Law of April 1991, which, for a decade mandated a one-to-one exchange rate between the Argentinepeso and the U.S. dollar. Another route by which countries arrive at a currency peg is the joining of a monetary union. Recent examples include Eastern European and Mediterraneanemerging countries, such as Greece, that joined the Eurozone.The Achilles’ heel of currency pegs is that they hinder the eﬃcient adjustment of theeconomy to negative external shocks, such as drops in the terms of trade or hikes in thecountry interest-rate premium. The reason is that such shocks produce a contraction inaggregate demand that requires a decrease in the relative price of nontradables, that is, areal depreciation of the domestic currency, in order to bring about an expenditure switchaway from tradables and toward nontradables. In turn, the required real depreciation maycome about via a nominal devaluation of the domestic currency or via a fall in nominal pricesor both. The currency peg rules out a devaluation. Thus, the only way the necessary realdepreciation can occur is through a decline in the nominal price of nontradables. However,if nominal prices, especially factor prices, are downwardly rigid, the real depreciation willtake place only slowly, causing recession and unemployment along the way.This paper investigates the question of how costly are currency pegs in terms of unem-ployment and welfare for an emerging economy facing external shocks. To this end, thepaper embeds downward nominal wage rigidity into a dynamic, stochastic, disequilibrium
Columbia University, CEPR, and NBER. E-mail: firstname.lastname@example.org.
Columbia University and NBER. E-mail: email@example.com.