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Currency Pegs and Unemployment

Currency Pegs and Unemployment

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Published by: stephen_fidler on Aug 04, 2010
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Currency Pegs and Unemployment
Stephanie Schmitt-Groh´e
Mart´ın Uribe
This draft: August 3, 2010Preliminary and incomplete
1 Introduction
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: stephanie.schmittgrohe@columbia.edu.
Columbia University and NBER. E-mail: martin.uribe@columbia.edu.
(DSDE) model of a small open economy with traded and nontraded goods. The key featurethat distinguishes our theoretical framework from existing models of nominal wage rigidityis that in our formulation wage rigidity gives rise to occasionally binding constraints thatprevent the real wage from falling to its efficient level. In turn, these constraints, when bind-ing, produce involuntary unemployment. A second distinguishing feature of our model of downward wage rigidity is that it does not rely on the assumption of imperfect competitionin product or factor markets. This feature of the model has implications for the wage settingprocess, which, as explained below, affects form of the optimal exchange-rate policy.We show that in our DSDE model, the optimal monetary policy takes the form of atime-varying rate of devaluation that allows the real wage to equal the efficient real wage atall times. The resulting optimal exchange-rate policy is highly asymmetric in nature. Thecentral bank devalues the nominal currency only in periods in which the full-employment realwage rate experiences a sizable decline. These are typically periods in which the economysuffers negative external shocks. In all other periods, the monetary authority keeps thenominal exchange rate constant. It follows that under the optimal policy, the devaluationrate is positive on average. As a consequence, the optimal rate of inflation is also positive onaverage. In this way, our DSDE model captures Olivera’s (1960, 1964) concept of structuralinflation.The first main quantitative result of this paper is that in a calibrated version of ourmodel, the average optimal rate of inflation is high, about 5 percent per year. This resultis important in light of the difficulties that the existing literature on the optimal rate of inflation has faced in rationalizing actual inflation targets, which in virtually all inflationtargeting countries are at least two percent. In this literature, the optimal rate of inflationis typically negative or insignificantly above zero (see Schmitt-Groh´e and Uribe, 2010, fora survey). The reason why the present DSDE model has the ability to generate sizableoptimal inflation rates is threefold. First, in our model labor markets are competitive. Thisimplies that no economic agent internalizes the downward rigidity of wages. By contrast, inan environment in which wage setters do internalize the wage rigidity, nominal (and real)wages tend to rise less during booms. Therefore, the central bank has an incentive to revalueduring booms and less need to devalue during recession, both of which tend to reduce theaverage level of inflation. Second, our model of wage rigidity imposes asymmetric costs of changing nominal wages. Firms face resistance only to nominal wage cuts, but not to nominalwage increases. This asymmetry creates an incentive for the central bank to inflate awaythe purchasing power of past real wages when they exceed the current full-employment realwage. On the other hand, the fact that nominal wages are flexible upward implies that thecentral bank has no incentives to deflate when the current full-employment real wage exceeds1
past real wages. Finally, our model implies that when the lower bound on nominal wagesis binding, the labor market is in disequilibrium and involuntary unemployment emerges.Importantly, the disequilibrium in the labor market obtains even if the supply of labor isperfectly inelastic.Our second main quantitative result is that currency pegs cause structural unemploymentand high welfare losses. In our calibrated economy, the average unemployment rate impliedby a currency peg lies between 1.3 and 7.1 percent above the natural rate, depending onthe degree of wage rigidity. The welfare costs of currency pegs range between 0.8 and 4.8percent of the consumption stream. This result is remarkable in light of the fact that inexisting models with nominal rigidities, the welfare cost of suboptimal monetary policy istypically much smaller. In our model, the large welfare costs stem from two sources: first,the structural unemployment associated with a currency peg implies lower average output.Second, a currency peg exacerbates the business-cycle fluctuations generated by externalshocks, by transmitting them to the nontraded sector.Finally, our investigation finds that the welfare cost of currency pegs as well as theform of the optimal exchange-rate policy both depend crucially on the assumed underlyingasset market structure. For instance, we find that under complete markets monetary policyis irrelevant, in the sense that the real allocation is optimal regardless of the exchange-ratepolicy followed by the central bank. By contrast, when the economy is closed to internationalfinancial markets, the optimal exchange rate policy calls for a high and variable devaluationrate and a currency peg can carry large welfare costs.The remainder of this incomplete draft is organized in four sections. Section 2 developsa model of unemployment due to downward wage rigidities with competitive labor marketsand embeds it into a dynamic stochastic small open economy. Section 3 characterizes theallocations in the private sector, taking government policy as given. Section 4 characterizesequilibrium under a currency peg and under the optimal exchange-rate policy in an economywith complete financial markets. Section 5 considers the polar case of financial autarky.
2 A Dynamic Stochastic Disequilibrium Model
In this section, we develop a model of a small open economy in which nominal wages are rigidonly downwardly, giving rise to an occasionally binding constraint. In the model, the labormarket is perfectly competitive. As a result, even though all participants understand thatwages are nominally rigid, they do not act strategically in their pricing behavior. Instead,workers and firms take factor prices as given. The model features a traded and a nontradedsector and aggregate fluctuations are driven by stochastic movements in the supply of traded2

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