Currency Pegs and Unemployment

Stephanie Schmitt-Groh´e

Mart´ın Uribe

This draft: August 3, 2010
Preliminary 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 in
a 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 Argentine
peso 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 Mediterranean
emerging countries, such as Greece, that joined the Eurozone.
The Achilles’ heel of currency pegs is that they hinder the efficient adjustment of the
economy to negative external shocks, such as drops in the terms of trade or hikes in the
country interest-rate premium. The reason is that such shocks produce a contraction in
aggregate demand that requires a decrease in the relative price of nontradables, that is, a
real depreciation of the domestic currency, in order to bring about an expenditure switch
away from tradables and toward nontradables. In turn, the required real depreciation may
come about via a nominal devaluation of the domestic currency or via a fall in nominal prices
or both. The currency peg rules out a devaluation. Thus, the only way the necessary real
depreciation 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 will
take 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, the
paper 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 feature
that distinguishes our theoretical framework from existing models of nominal wage rigidity
is that in our formulation wage rigidity gives rise to occasionally binding constraints that
prevent 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 competition
in product or factor markets. This feature of the model has implications for the wage setting
process, 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 a
time-varying rate of devaluation that allows the real wage to equal the efficient real wage at
all times. The resulting optimal exchange-rate policy is highly asymmetric in nature. The
central bank devalues the nominal currency only in periods in which the full-employment real
wage rate experiences a sizable decline. These are typically periods in which the economy
suffers negative external shocks. In all other periods, the monetary authority keeps the
nominal exchange rate constant. It follows that under the optimal policy, the devaluation
rate is positive on average. As a consequence, the optimal rate of inflation is also positive on
average. In this way, our DSDE model captures Olivera’s (1960, 1964) concept of structural
inflation.
The first main quantitative result of this paper is that in a calibrated version of our
model, the average optimal rate of inflation is high, about 5 percent per year. This result
is 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 inflation
targeting countries are at least two percent. In this literature, the optimal rate of inflation
is typically negative or insignificantly above zero (see Schmitt-Groh´e and Uribe, 2010, for
a survey). The reason why the present DSDE model has the ability to generate sizable
optimal inflation rates is threefold. First, in our model labor markets are competitive. This
implies that no economic agent internalizes the downward rigidity of wages. By contrast, in
an 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 revalue
during booms and less need to devalue during recession, both of which tend to reduce the
average 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 nominal
wage increases. This asymmetry creates an incentive for the central bank to inflate away
the purchasing power of past real wages when they exceed the current full-employment real
wage. On the other hand, the fact that nominal wages are flexible upward implies that the
central bank has no incentives to deflate when the current full-employment real wage exceeds
1
past real wages. Finally, our model implies that when the lower bound on nominal wages
is 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 is
perfectly inelastic.
Our second main quantitative result is that currency pegs cause structural unemployment
and high welfare losses. In our calibrated economy, the average unemployment rate implied
by a currency peg lies between 1.3 and 7.1 percent above the natural rate, depending on
the degree of wage rigidity. The welfare costs of currency pegs range between 0.8 and 4.8
percent of the consumption stream. This result is remarkable in light of the fact that in
existing models with nominal rigidities, the welfare cost of suboptimal monetary policy is
typically 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 external
shocks, by transmitting them to the nontraded sector.
Finally, our investigation finds that the welfare cost of currency pegs as well as the
form of the optimal exchange-rate policy both depend crucially on the assumed underlying
asset market structure. For instance, we find that under complete markets monetary policy
is irrelevant, in the sense that the real allocation is optimal regardless of the exchange-rate
policy followed by the central bank. By contrast, when the economy is closed to international
financial markets, the optimal exchange rate policy calls for a high and variable devaluation
rate and a currency peg can carry large welfare costs.
The remainder of this incomplete draft is organized in four sections. Section 2 develops
a model of unemployment due to downward wage rigidities with competitive labor markets
and embeds it into a dynamic stochastic small open economy. Section 3 characterizes the
allocations in the private sector, taking government policy as given. Section 4 characterizes
equilibrium under a currency peg and under the optimal exchange-rate policy in an economy
with 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 rigid
only downwardly, giving rise to an occasionally binding constraint. In the model, the labor
market is perfectly competitive. As a result, even though all participants understand that
wages 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 nontraded
sector and aggregate fluctuations are driven by stochastic movements in the supply of traded
2
goods.
2.1 Households
The economy is populated by a large number of infinitely-lived households with preferences
described by the utility function
E
0

¸
t=0
β
t
U(c
t
), (1)
where c
t
denotes consumption, U is a utility index assumed to be increasing and strictly
concave, β ∈ (0, 1) is a subjective discount factor, and E
t
is the expectations operator
conditional on information available in period t. Consumption is assumed to be a composite
good made of tradable and nontradable goods via the aggregation process
c
t
= A(c
T
t
, c
N
t
), (2)
where c
T
t
denotes consumption of tradables, c
N
t
denotes consumption of nontradables, and
A denotes an aggregator function assumed to be homogeneous of degree one, increasing,
concave, and to satisfy the Inada conditions. These assumptions imply that consumption of
tradables and nontradables are normal goods.
Households are assumed to be endowed with an exogenous and stochastic amount of
tradable goods, y
T
t
, and a constant number of hours,
¯
h, which they supply inelastically to
the labor market. Because of the presence of nominal wage rigidities in the labor market,
households will in general only be able to work h
t

¯
h hours each period. Households take
h
t
as exogenously determined. Households also receive from the government a lump-sum
transfer τ
t
and profits from the ownership of firms, denoted φ
t
. Both τ
t
and φ
t
are expressed
in terms of tradables. Following Mendoza and Yue (2010), we assume that households
do not directly participate in financial markets. Instead, the government does so on their
behalf by choosing transfers in a benevolent fashion. We make this assumption for technical
reasons, as it greatly facilitates the characterization and computation of equilibrium in an
economy with occasionally binding constraints and possibly incomplete asset markets. The
household’s budget constraint in period t is then given by
c
T
t
+ p
t
c
N
t
= y
T
t
+ w
t
h
t
+ φ
t
+ τ
t
, (3)
where p
t
denotes the relative price of nontradables in terms of tradables in period t and
w
t
denotes the real wage rate in terms of tradables in period t. The household takes the
right-hand side of the budget constraint as exogenously given.
3
In each period t ≥ 0, the optimization problem of the household consists in choosing
c
T
t
and c
N
t
to maximize (2) subject to the budget constraint (3). The optimality conditions
associated with this maximization problem are the budget constraint (3) and
A
2
(c
T
t
, c
N
t
)
A
1
(c
T
t
, c
N
t
)
= p
t
,
where A
i
denotes the partial derivative of A with respect to its i-th argument. Intuitively,
the above expression states that an increase in the relative price of nontradables induces
households to engage in expenditure switching by consuming relatively more tradables and
less nontradables. The maintained assumptions on the form of the aggregator function A
guarantee that the left-hand side of this expression is an increasing function of the ratio
c
T
t
/c
N
t
.
2.2 Firms
The nontraded good is produced using labor as the sole input by means of an increasing and
concave production function
y
N
t
= F(h
t
),
where y
N
t
denotes output of nontradables. The firm operates in competitive product and
labor markets. Profits, φ
t
, are given by
φ
t
= p
t
F(h
t
) −w
t
h
t
.
The firm chooses h
t
to maximize profits. The optimality condition associated with this
problem is
p
t
F

(h
t
) = w
t
.
This first-order condition implicitly defines the firm’s demand for labor. It states that firms
are always on their labor demand curve. Put differently, in this model firms never display
unfilled vacancies nor are forced to keep undesired positions. As we will see shortly, this will
not be the case for workers, who will in general be off their labor supply schedule and will
experience involuntary unemployment.
2.3 Employment and Wages with Downward Nominal Rigidity
Let W
t
denote the nominal wage rate and E
t
the nominal exchange rate, defined as the
domestic-currency price of one unit of foreign currency. Assume that the law-of-one-price
4
holds for traded goods and that the foreign-currency price of traded goods is constant and
normalized to unity. Then, the real wage in terms of tradables is given by w
t
≡ W
t
/E
t
.
Nominal wages are assumed to be downwardly rigid in the spirit of Olivera (1960, 1964).
Specifically, in any given period nominal wages can at most fall by a factor γ ∈ [0, 1].
Formally, we impose that
W
t
≥ γW
t−1
.
This setup nests the cases of absolute downward rigidity, when γ → 1, and full wage flexi-
bility, when γ → 0. The presence of nominal wage rigidity implies the following restriction
on the dynamics of real wages:
w
t
≥ γ
w
t−1

t
,
where
t
≡ E
t
/E
t−1
denotes the gross nominal depreciation rate of the domestic currency.
The presence of downwardly rigid nominal wages implies that the labor market will in
general not clear at the inelastically supplied level of hours
¯
h. Instead, involuntary unem-
ployment, given by
¯
h − h
t
, will be a regular feature of this economy. Actual employment
must satisfy
h
t

¯
h
at all times. Finally, at any point in time, real wages and employment must satisfy the
slackness condition
(
¯
h −h
t
)

w
t
−γ
w
t−1

t

= 0.
2.4 Price and Quantity Determination in the Private Sector
Given the level of government transfers, τ
t
, and the devaluation rate,
t
, which are both
determined by government policy and taken as exogenous by households and firms, and
given the past real wage, w
t−1
, which is a predetermined variable, relative prices, p
t
and
w
t
, and quantities, c
T
t
, c
N
t
, and h
t
, are determined by the following system of equations and
inequalities:
c
N
t
= F(h
t
), (4)
c
T
t
= y
T
t
+ τ
t
, (5)
A
2
(c
T
t
, c
N
t
)
A
1
(c
T
t
, c
N
t
)
= p
t
, (6)
p
t
F

(h
t
) = w
t
, (7)
(
¯
h −h
t
)

w
t
−γ
w
t−1

t

= 0, (8)
5
h
t

¯
h, (9)
and
w
t
≥ γ
w
t−1

t
. (10)
Consider first the real wage that would obtain in a full-employment equilibrium in which
h
t
equals
¯
h. Setting h
t
=
¯
h and using equation (4) to eliminate c
N
t
, equation (5) to eliminate
c
T
t
, and equation (6) to eliminate p
t
, the labor demand equation (7) can be written as
w
f,t
=
A
2
(y
T
t
+ τ
t
, F(
¯
h))
A
1
(y
T
t
+ τ
t
, F(
¯
h))
F

(
¯
h) ≡ Ω
f
(y
T
t
+ τ
t
); Ω

f
> 0, (11)
where w
f,t
denotes the full-employment real wage. The assumed properties of the aggrega-
tor function A guarantee that the full-employment real wage is increasing in after-transfer
tradable income y
T
t
+ τ
t
. The intuition behind this result is that an increase in tradable
income makes households feel richer. Because nontradables are normal goods, the demand
for this type of good goes up. The supply of nontradables, however, cannot increase because
the labor market is already in full employment. Therefore, the relative price of nontradables
must rise. This increase in the relative price of nontradables raises the value of the marginal
product of labor, which translates into an increase in the real wage.
Using the above expression for the full-employment wage, equation (11), and condi-
tion (10), we have that the real wage rate satisfies
w
t
= Ω

y
T
t
+ τ
t
,
w
t−1

t

≡ max

γ
w
t−1

t
, Ω
f
(y
T
t
+ τ
t
)

; Ω
1
, Ω
2
≥ 0. (12)
Having derived the real wage rate that will prevail in each period, one can use expres-
sions (4)-(7) to obtain the value of all other variables determined in the private sector. In
particular, employment is implicitly give by
A
2
(y
T
t
+ τ
t
, F(h
t
))
A
1
(y
T
t
+ τ
t
, F(h
t
))
F

(h
t
) = Ω

y
T
t
+ τ
t
,
w
t−1

t

.
The normality of tradable and nontradable consumption guarantees that the left-hand side
of this expression is monotonically decreasing in h
t
. This fact in combination with the
assumptions that A satisfies the Inada conditions and that F is concave implies that, given
y
T
t
+ τ
t
and w
t−1
/
t
, there exists a unique solution of the above expression for employment,
h
t
, which satisfies h
t

¯
h. We therefore can express employment as a function of y
T
t

t
and
6
w
t−1
/
t
as follows:
h
t
= H

y
T
t
+ τ
t
,
w
t−1

t

; H
1
≥ 0; H
2
≤ 0.
The results that H is nondecreasing in y
T
t

t
and nonincreasing in w
t−1
/
t
follows from the
properties of the functions A and Ω. The intuition for why employment is nondecreasing
in tradable income is that an increase in this source of income produces a positive wealth
effect that raises the demand for both tradable and nontradable goods. If the economy is
operating below full employment, the increase in the demand for nontradables translates
directly into an increase in employment in that sector. If the economy is already operating
at full employment, the increase in the demand for nontradables causes a rise in the price
of this type of good but leaves employment unchanged. Consider now an increase in the
lower bound for real wages, w
t−1
/
t
. If this lower bound is binding an increase in w
t−1
/
t
will depress employment, because firms are always operating on the labor demand schedule
(i.e., employment is demand determined). On the other hand, if the economy is at full
employment, then an increase in w
t−1
/
t
is in general not binding and has no effect on
employment.
Finally, one can express the relative price of nontradables, consumption of nontradables,
and total consumption as functions of tradable income and the real value of the lagged wage
rate as follows:
p
t
=
A
2

y
T
t
+ τ
t
, F

H

y
T
t
+ τ
t
,
w
t−1
t

A
1

(y
T
t
+ τ
t
, F

H

y
T
t
+ τ
t
,
w
t−1
t
≡ P(y
T
t
+ τ
t
,
w
t−1

t
); P
1
> 0, P
2
≤ 0,
c
N
t
= F

H

y
T
t
+ τ
t
,
w
t−1

t

≡ C
N

y
T
t
+ τ
t
,
w
t−1

t

; C
N
1
≥ 0; C
N
2
≤ 0,
c
t
= A

y
T
t
+ τ
t
, C
N

y
T
t
+ τ
t
,
w
t−1

t

≡ C

y
T
t
+ τ
t
,
w
t−1

t

; C
1
≥ 0, C
2
≤ 0,
where P
i
, C
N
i
, and C
i
denote, respectively, the partial derivatives of the functions P, C
N
,
and C with respect to their i-th arguments, for i = 1, 2. The signs of the partial derivatives
of these three functions follow directly from the previous analysis, with the exception of
P
1
, the partial derivative of the relative price of nontradables, p
t
, with respect to traded
income, y
T
t
+ τ
t
. The reason why the sign of this partial derivative is not obvious is that
the relative price of nontradables depends on the ratio of the consumptions of tradables and
nontradables. In turn, both tradable and nontradable consumption increase with tradable
income. It is possible to show, however, that an increase in tradable income will always induce
a proportionally larger increase in tradable consumption than in nontradable consumption.
7
Figure 1: The Effect of Transfers and Devaluations on the Private Sector
¯
h
Transfer, τ
t
Hours, h
t
γ
wt−1
t
Transfer, τ
t
Real Wages, w
t
Transfer, τ
t
Price of Nontradables, p
t
Transfer, τ
t
Aggregate Consumption, c
t
¯
h
Devaluation Rate,
t
Hours, h
t
←γ
wt−1
t
Devaluation Rate,
t
Real Wages, w
t
Devaluation Rate,
t
Price of Nontradables, p
t
Devaluation Rate,
t
Aggregate Consumption, c
t
8
To see this, consider first a situation in which the economy is at full employment. In this case,
consumption of nontradables cannot increase with tradable income, because nontradable
production is at its upper bound F(
¯
h). Tradable consumption, however, increases one for
one with tradable income. Hence, given the assumed properties of the aggregator function
A, the ratio A
2
/A
1
, which equals p
t
, must rise. Consider now a situation in which the
economy is operating below full employment. Suppose that in response to an increase in
tradable income c
N
increases by the same or a larger proportion than c
T
t
. By equation (6)
and the assumptions made about the aggregator A, this is the only scenario under which
the relative price of nontradables, p
t
, will not rise. This scenario, however, is impossible.
To see this, note that the rise in c
N
t
must be accompanied by a rise in h
t
(by equation (4)),
and, hence by a decline in the marginal product of labor (by the assumed concavity of the
production function F). Now, the fact that p
t
does not increase and that F

(h
t
) falls, implies,
by the labor demand given in (7), that the real wage must fall. But because the economy
is operating below full employment, the real wage is at its lower bound γw
t−1
/
t
and thus
cannot fall further. It follows that p
t
must rise.
Figure 1 provides a graphical summary of the dependence of hours, the real wage rate,
the relative price of nontradables and total consumption on the real transfer τ
t
and the
devaluation rate
t
. The left column of figure 1 displays qualitatively the effect of changes
in transfers on the private sector. If the economy is operating below full employment, an
increase in transfers brings about a reduction in involuntary unemployment, a real appreci-
ation (i.e., an increase in the relative price of nontradables), and an expansion in aggregate
consumption. Note that in this case, employment increases even though real wages are un-
changed and firms are on their demand schedule. The reason is that the relative price of
nontradables increases, thereby boosting the value of the marginal product of labor.
Consider now the macroeconomic effect of a devaluation, starting from a situation in
which the economy exhibits involuntary unemployment. The effects are illustrated in the
right column of figure 1. The primary effect of a devaluation is to lower the real wage when
wage rigidities are binding. In this case, the devaluation boosts employment by reducing
labor costs. The resulting increase in the supply of nontradables causes their relative price
to fall, allowing consumers to switch expenditures toward this type of good. The ability of
devaluations to stimulate private spending ceases once the economy reaches full employment.
We note that figure 1 considers partial equilibrium effects in which either transfers or
the devaluation rate are held constant. In general equilibrium, these two variables are
endogenously determined by the government’s transfer and exchange rate policies. We turn
now to a characterization of the government’s policy problem.
9
2.5 The Government
The government is assumed to choose the process for transfers, τ
t
, in a benevolent fashion,
in the sense of maximizing the welfare of private households. The government’s objective
function is to maximize the lifetime utility of the representative household taking into account
the resource allocations that result in the private sector through the optimizing behavior of
households and firms. Formally, the objective function of the government is given by
E
0

¸
t=0
β
t
˜
U

y
T
t
+ τ
t
,
w
t−1

t

, (13)
where
˜
U is an indirect utility function given by
˜
U

y
T
t
+ τ
t
,
w
t−1

t

≡ U

C

y
T
t
+ τ
t
,
w
t−1

t

;
˜
U
1
> 0;
˜
U
2
≤ 0.
The optimal transfer process will depend, in general, on the assumed structure of financial
markets and on the monetary policy implemented by the central bank. The central focus of
this paper is the interaction between financial structure and the effectiveness of monetary
policy in an economy with downward nominal wage rigidity. We turn next to a description
of monetary policy.
3 Full-Employment Exchange-Rate Policy And Cur-
rency Pegs
We consider two polar exchange-rate arrangements. The first one is a currency peg. This
policy regime is meant to capture, for example, the monetary policy in place in Argentina
prior to the default episode of 2001 and the monetary restrictions faced by the small emerging
economies that are members of the Eurozone, such as Greece and Portugal. Under a currency
peg the government commits to keeping the nominal exchange rate constant over time,
E
t
= E
t−1
for t ≥ 0. As a result, the gross rate of devaluation equals unity at all times:

t
= 1,
for t ≥ 0.
Under a currency peg, relative prices and quantities in the private sector are determined
10
as functions of τ
t
and w
t−1
only as follows:
w
t
= Ω

y
T
t
+ τ
t
, w
t−1

, (14)
h
t
= H

y
T
t
+ τ
t
, w
t−1

, (15)
p
t
= P

y
T
t
+ τ
t
, w
t−1

, (16)
c
N
t
= C
N

y
T
t
+ τ
t
, w
t−1

, (17)
c
T
t
= y
T
t
+ τ
t
,
and
c
t
= C

y
T
t
+ τ
t
, w
t−1

. (18)
The second exchange-rate arrangement we consider is one in which the central bank
always sets the devaluation rate to ensure full employment in the labor market. We refer
to this monetary arrangement as the full-employment exchange-rate policy. Formally, this
policy amounts to setting the devaluation rate to ensure that the real wage equals the full-
employment wage rate, w
f,t
, at all times. We assume that, if w
f,t
is greater than γw
t−1
,
then the monetary authority keeps the nominal exchange rate constant, that is,
t
= 1.
There is no need for a devaluation in this case, because the nominal wage rate will adjust
upward on its own accord—recall that nominal wages are fully flexible upward. If, on the
other hand, w
f,t
is lower than γw
t−1
, then the monetary authority chooses
t
to ensure
that w
f,t
= γw
t−1
/
t
. In this case, if the central bank chose not to devalue, the economy
would experience unemployment, because downward wage rigidities would prevent the real
wage from falling to the flexible-wage level w
f,t
. It follows that under the full-employment
devaluation policy, the devaluation rate is given by

t
= max

γ
w
t−1
w
f,t
, 1

.
This exchange-rate policy ensures that in every period t > 0, the real wage rate equals the
full-employment real wage:
w
t
= Ω
f
(y
T
t
, τ
t
). (19)
Thus, using equation (11), we can write

t
= max

γ

f
(y
T
t−1
+ τ
t−1
)

f
(y
T
t
+ τ
t
)
, 1

; t > 0. (20)
Because Ω
f
is a strictly increasing function of tradable income, this expression states that
11
the central bank will devalue the domestic currency only when tradable income falls. Be-
cause in equilibrium traded consumption equals tradable income, we have that the monetary
authority devalues only when tradable expenditure falls.
The full-employment exchange-rate policy guarantees that the labor market is always at
full employment:
h
t
=
¯
h, (21)
for all t ≥ 0. This means that output of nontradables is constant, at y
N
t
= F(
¯
h), and therefore
so is nontraded consumption,
c
N
t
= F(
¯
h). (22)
We then have, using equation (6), that the relative price of nontradables under the full-
employment exchange-rate policy is given by
p
t
=

f
(y
T
t
+ τ
t
)
F

(
¯
h)
. (23)
Finally, aggregate consumption is determined by
c
t
= A(y
T
t
+ τ
t
, F(
¯
h)). (24)
We have demonstrated that the full-employment exchange-rate policy completely eliminates
any effect that downward nominal wage rigidities may have on the real allocation. Put
differently, under the monetary regime assumed here, the economy becomes identical to one
with full wage flexibility. Indeed, in the context of our model, the full-employment exchange-
rate policy is always optimal. The reason is that, when the nontraded sector operates at full
employment, the equilibrium real allocation depends only on the level of transfers, which, in
turn, as will become clear shortly, is independent of the devaluation rate process.
4 Devaluation Incentives Under Complete Asset Mar-
kets
As a useful benchmark environment, we consider an economy with access to a complete
array of state-contingent claims. The main purpose of studying this type of asset structure
is to show that in emerging economies in which external shocks play an important role, the
country’s ability to insure against such shocks greatly simplifies the monetary-policy problem.
This benchmark will then be contrasted with environments featuring different forms of asset-
market incompleteness in which monetary policy will play a central stabilizing role.
12
Under complete asset markets, the budget constraint of the government is given by
τ
t
+ d
t
= E
t
q

t,t+1
d
t+1
, (25)
where d
t+1
is a state-contingent payment of the government to its international creditors
chosen in period t. The random variable d
t+1
can take on positive or negative values. A
positive value of d
t+1
in a particular state of period t + 1 can be interpreted as the external
debt due in that state and date. The variable q

t,t+j
denotes the period-t price of an asset
that pays one unit of tradable good in one particular state of period t + j divided by the
probability of occurrence of that particular state conditional upon information available in
period t. It follows that E
t
q

t,t+1
d
t+1
is the period-t price of the state-contingent payment
d
t+1
. The government faces a borrowing limit of the form
lim
j→∞
E
t
q

t,t+j
d
t+j
≤ 0, (26)
which prevents Ponzi schemes.
The government chooses processes {τ
t
, d
t+1
, w
t
} to maximize the indirect utility func-
tion (13) subject to (12), (25), and (26), given d
0
, w
−1
, the process q

t,t+1
, the endowment
process y
T
t
, and a monetary policy regime. The first-order condition with respect to d
t+1
is
λ
t
q

t,t+1
= βλ
t+1
,
where λ
t
denotes the Lagrange multiplier on the government’s budget constraint (25). For-
eign households are assumed to have access to the same array of contingent claims available
to domestic agents. Thus, the following Euler equation holds abroad:
λ

t
q

t,t+1
= βλ

t+1
,
where λ

t
denotes the marginal utility of tradable consumption of foreign residents. Note
that we assume that domestic and foreign residents have the same subjective discount fac-
tor. Because the above two expressions hold on a state-by-state and date-by-date basis,
they imply that the domestic and foreign marginal utilities of consumption of tradables are
proportional to each other at all dates and states:
λ
t
= δλ

t
,
where δ > 0 is a constant reflecting a wealth differential between the domestic and the
foreign economies. We will assume that the country faces no systemic uncertainty from
13
abroad. Therefore, we set λ

t
= λ

, where λ

is a positive constant. It then follows that λ
t
is constant as well:
λ
t
= δλ

.
We wish to show that when financial markets are complete, full-employment at all times
is a solution to the government’s problem independently of whether the government follows
an exchange-rate peg or a full-employment exchange-rate policy. To this end, we solve the
government’s maximization problem without imposing restriction (12) and then show that
the solution to the less-constrained optimization problem indeed satisfies this constraint.
1
The first-order condition with respect to the transfer τ
t
is given by
U

(c
t
)
¸
A
1
(c
T
t
, c
N
t
) + A
2
(c
T
t
, c
N
t
)C
N
1

y
T
t
+ τ
t
,
w
t−1

t

= λ. (27)
Now consider a solution in which c
N
t
= F(
¯
h) for all t. In this case, first-order condition (27)
implies that consumption of tradables, c
T
t
= y
T
t
+ τ
t
, is constant across states and time,
at a level that we denote by c
T
. Replacing τ
t
by c
T
− y
T
t
in the sequential budget con-
straint of the government, equation (25), iterating forward, and imposing the no-Ponzi-game
constraint (26), one obtains
c
T
= (1 −β)
¸
−d
0
+E
0

¸
t=0
β
t
y
T
t
¸
.
Let the wage rate be constant over time and given by:
w
t
=
A
2
(c
T
, F(
¯
h))
A
1
(c
T
, F(
¯
h))
F

(
¯
h). (28)
The right-hand side of this expression is the full-employment wage rate associated with
y
T
t
+ τ
t
= c
T
. What remains to be shown is that the suggested path of wages given in
equation (28) satisfies the omitted constraint (12) for both monetary policies considered.
This amounts to verifying that w
t
≥ γw
t−1
/
t
for t ≥ 0 when w
t
is given by (28). Notice
that for any t > 0, w
t
= w
t−1
. Note also that
t
= 1 for t > 0 under both a currency peg and
the full-employment exchange-rate policy. The fact that
t
= 1 under the full-employment
exchange-rate policy follows from equation (20) and the facts that γ < 1 and that, because
y
T
t
+ τ
t
= c
T
is constant, the full-employment real wage rate is also constant constant for
t ≥ 0. Therefore, because γ ≤ 1 for any t > 0, equation (12) holds for both monetary regimes.
1
Alternatively, it is possible to impose (12) as a constraint and show that under the proposed full-
employment solution, the Lagrange multiplier associated with (12) is nil.
14
It remains to show that under our proposed real wage rate, equation (12) holds at t = 0.
Suppose monetary policy takes the form of an exchange rate peg. Then equation (12) holds
in period 0 as long as γw
−1
≤ w
0
. We will assume that the initial condition, w
−1
, is such
that this condition is satisfied.
2
Alternatively, if the central bank follows a full-employment
exchange rate policy, then equation (12) will be satisfied if and only if γw
−1
/
0
≤ w
0
. The
government can always pick
0
so that this condition is met.
We have shown that, when asset markets are complete, the full-employment allocation
results under both monetary policies. The intuition for this result is that the fact that
the benevolent government has access to complete asset markets allows households to com-
pletely smooth consumption across dates and states. In this case stochastic variations in
tradable output only affect the transfer payments, but not consumption allocations. With
consumption constant over time, nominal rigidities no longer play any role in equilibrium
determination. We summarize this result in the following proposition:
Proposition 1 When financial markets are complete, the optimal transfer policy guarantees
full employment at all dates and times regardless of whether monetary policy is characterized
by a currency peg or by the full-employment exchange-rate-policy.
The stochastic environment considered in this section, featuring a single shock to tradable
output, was deliberately constructed to yield the strong monetary-policy-irrelevance result
of proposition 1. Our main interest is not however, the message of the proposition in its
strongest sense, but rather to build a benchmark scenario that is analytically tractable and
transparent to convey the main idea of the present study, namely that when key nominal
prices are downwardly rigid, the real consequences of monetary policy are greatly influenced
by the underlying financial structure. The usefulness of this strategy will become apparent in
the next section when the macroeconomic consequences of a currency peg in an environment
with complete asset markets are contrasted with its consequences in an environment of
financial autarky.
5 Devaluation Incentives Under Financial Autarky
Under financial autarky, the government is unable to borrow or lend internationally. As a
result, transfers equal zero at all times
τ
t
= 0,
2
One can show that if this initial condition is not satisfied, then a currency peg gives rise initially to
involuntary unemployment. However, after a finite number of periods, the economy reaches full employment
forever. In this case, therefore, a currency peg yields full employment up to a finite initial transition.
15
and consumption of tradables equals tradable output
c
T
t
= y
T
t
.
This represents a sharp contrast with the case of complete asset markets, in which consump-
tion of tradables is perfectly constant across dates and states.
More importantly for the purpose of our study is that under financial autarky, unlike in
the case of complete asset markets, the dynamics of the nontraded sector depend crucially
upon the assumed exchange-rate regime. Under the full employment exchange-rate policy,
nontraded consumption is constant over time and equal to F(
¯
h). This perfect smoothness
in nontradable consumption is the result of optimal monetary policy, which deflates the real
value of past wages whenever the efficient allocation requires a reduction in the equilibrium
real wage by a factor greater than 1 −γ, a situation that happens when the tradable sector
is contracting. Formally, setting τ
t
= τ
t−1
= 0 in equation (20), we obtain the following
expression for the optimal devaluation rate under financial autarky

t
= max

γ

f
(y
T
t−1
)

f
(y
T
t
)
, 1

; t > 0. (29)
Because the function Ω
f
is strictly increasing, this expression states that the central bank
optimally devalues the domestic currency only when tradable output falls, y
T
t
< y
T
t−1
.
These devaluations are designed to undue nominal frictions in states in which they would
otherwise be binding. Because in this economy devaluations occur when the economy is
contracting, non-micro founded statistical analysis would conclude that devaluations are
contractionary. However, the role of devaluations in this model is precisely the opposite,
namely, to prevent the contraction in the tradable sector to spill over into the nontraded
sector. It follows that in this economy devaluations are indeed expansionary in the sense that
should they not take place, aggregate contractions would be even larger. Thus, under the
optimal exchange-rate regime, our model with downward nominal rigidities turns the view
that ‘devaluations are contractionary’ on its head and instead predicts that ‘contractions are
devaluatory.’
Under the optimal monetary policy, the average devaluation rate is positive (E
t
> 1).
This result follows directly form the fact that, by equation (29), the equilibrium gross deval-
uation rate is time varying and bounded below by unity. The inflation rate in the nontraded
sector is also positive on average. To see this, notice that the relative price of nontradables,
p
t
, is given by the ratio of the nominal price of nontradables and the nominal exchange
rate. Because in our model the relative price of nontradables is a stationary variable and
16
the nominal exchange rate grows on average at a positive rate, it follows that the nominal
price of nontradables must also grow on average at a positive rate, which means that the
inflation rate in the nontraded sector must be positive on average. The aggregate rate of
inflation is then also positive on average, because it is a weighted average of the inflation
rates of the traded and nontraded sectors. Therefore, our model formalizes Olivera’s (1960,
1964) structural or nonmonetary theory of the optimality of positive inflation.
3
When the exchange-rate policy takes the form of a currency peg, macroeconomic dynam-
ics are characterized by equations (14)-(18) evaluated at τ
t
= 0 for all t. As in the case
of the optimal exchange-rate-policy, consumption of tradables equals tradable output at all
times, c
T
t
= y
T
t
. But the dynamics of employment, wages, and the real exchange rate are
quite different across the two monetary regimes. Under a currency peg, the economy will
display involuntary unemployment whenever the full employment wage rate, Ω
f
(y
T
t
), falls
below γw
t−1
. Because Ω
f
is strictly increasing, it follows that involuntary unemployment is
more likely to emerge the larger is the contraction in the tradable sector.
To illustrate the predictions of our model we perform a numerical simulation. We assume
a CRRA form for the period utility function, a CES form for the aggregator function and
an isoelastic form for the production function of nontradables:
U(c) =
c
1−σ
−1
1 −σ
,
A(c
T
, c
N
) =

a(c
T
)
1−
1
ξ
+ (1 −a)(c
N
)
1−
1
ξ
ξ
ξ−1
,
and
F(h) = h
α
.
We calibrate the model at a quarterly frequency using data from Argentina. Reinhart and
V´egh (1995) estimate the intertemporal elasticity of substitution to be 0.21, using Argentine
quarterly data. We therefore set σ equal to 5. We normalize the steady-state levels of
output of tradables and hours at unity. The parameter a then represents the share of traded
consumption in total consumption. We set this parameter at 0.26, which is the share of
traded output observed in Argentine data over the period 1980:Q1-2010:Q1. This approach
to calibrating the share of tradable consumption is justified in the context of a model without
investment and with financial autarky. We set the elasticity of substitution between traded
and nontraded consumption, ξ, to 0.44 following the estimates of Stockman and Tesar (1995).
Following Uribe’s (1997) evidence on the size of the labor share in the nontraded sector in
Argentina, we set α equal to 0.75.
3
See also Tobin (1972).
17
Table 1: Calibration
Parameter Value Description
σ 5 Inverse of intertemporal elasticity of consumption
a 0.26 Share of tradables
ξ 0.44 Elasticity of substitution between tradables and nontradables
α 0.75 Labor share in nontraded sector
¯
h 1 Labor endowment
y
T
1 Steady-state tradable output
ρ 0.90 Serial correlation of log tradable output
σ
T
0.0355 Standard deviation of innovation to log of tradable output
β 0.953 Quarterly subjective discount factor
r

0.02 Quarterly world interest rate
η 0.0002 Debt sensitivity of country premium
γ 0.99,0.95,0.9 Degree of downward nominal wage rigidity
The driving force in our model is the stochastic process for tradable output. Our empirical
measure of y
T
t
is Argentine GDP in agriculture, forestry, fishing, mining, and manufacturing.
After removing a log-quadratic time trend, we estimate the following AR(1) process using
data over the period 1980:Q1 to 2010:Q1:
ln(y
T
t
/y
T
) = ρ ln(y
T
t−1
/y
T
) + σ
T

t
, (30)
where
t
is white noise with mean zero and variance equal to one. Our OLS estimates of ρ
and σ
T
are, respectively, 0.90 and 0.0355.
A key parameter in our model is γ, which measures the ability of firms to cut nominal
wages without facing worker resistance. To our knowledge, no econometric estimate of this
parameter exists. One difficulty in estimating γ is that it belongs to an occasionally binding
constraint. Therefore, the econometrician cannot rely on an equation that holds in every
period and features γ among its parameters. Also, empirical evidence on the observed
frequency of nominal wage cuts, taken in isolation, is in general not informative about the
size of γ. The reason is that the frequency of observed wage cuts in general depends on the
underlying monetary regime. For example, in the calibrated economy studied here, when
γ equals 0.95, nominal-wage cuts occur 60 percent of the time under an exchange-rate peg,
and 50 percent of the time under the optimal policy. These figures could erroneously be
interpreted as meaning that in the currency-peg economy nominal wages are less rigid than
in the optimal-monetary-policy economy. These arguments suggest that γ must be estimated
in the context of a fully-specified general equilibrium model featuring a full description not
only of the incentives of households, workers, and firms, but also of government policy.
18
Table 2: Inflation, Unemployment, and Welfare
Wage Mean Inflation Mean Unemployment Std. Dev. log(c
t
) Welfare
Stickiness Optimal Currency Optimal Currency Optimal Currency Cost
γ Policy Peg Policy Peg Policy Peg of Peg
A. Complete Asset Markets
all 0 0 0 0 0 0 0
B. Financial Autarky
0.99 12.01 0.01 0.00 7.08 2.10 5.47 4.88
0.95 5.60 0.00 0.00 1.33 2.10 2.88 0.84
0.90 1.66 0.00 0.00 0.26 2.10 2.25 0.16
Note. The inflation rate is expressed in percent per year. The mean unemployment rate and the
standard deviation of the log of consumption is in percent. The welfare cost of a peg is calculated
as the percentage increase in the entire consumption path associated with a peg required to yield
the same level of welfare as under the optimal monetary policy.
Therefore, we perform our simulations for three alternative values of γ, 0.99, 0.95, and 0.9.
We consider a value of γ of 0.9 to represent a case of high wage flexibility. For in this case
every firm in the economy can cut nominal wages by 40 percent each year without incurring
any cost or resistance on the part of workers. On the other hand, we interpret the case of
γ = 0.99, as representing a situation of relatively high downward nominal rigidity. For in
this case firms face high resistance to any wage cuts larger than 4 percent per year. The
case of γ = 0.95 represents a situation of intermediate nominal wage rigidity, in which firms
can cut nominal wages by 20 percent in one year, without facing much resistance. Table 1
summarizes the calibration of the model.
Table 2 displays model predictions for the average inflation rate, the average rate of
unemployment, consumption volatility, and the welfare cost of a currency peg. Panel A of the
table presents the results derived theoretically for the economy with complete asset markets.
In this economy, agents are able to fully smooth consumption. As a result, monetary policy is
irrelevant, and, in particular, the welfare cost of a currency peg is nil. By contrast, in the case
of financial autarky, shown in panel B of table 2, monetary policy can play an important role
in moderating the aggregate effects of external shocks when nominal wages are downwardly
rigid. Under the optimal policy regime, the average rate of inflation is 5.6 percent per year
at the intermediate level of downward wage rigidity (γ = 0.95). As explained earlier, the
optimality of positive average inflation is explained by the central bank’s policy of inflating
away the purchasing power of nominal wages when equilibrium in the labor market requires
cuts in real labor costs.
By contrast, the average rate of inflation is virtually zero under a currency peg regardless
19
of the degree of downward wage rigidity. To see why inflation is near zero under a currency
peg, we note that with a CES aggregator of tradables and nontradables, the consumer price
index is given by
P
t
=

a
ξ
E
1−ξ
t
+ (1 −a)
ξ
P
N
t
1−ξ
1
1−ξ
,
where P
t
denotes the nominal price of one unit of the composite consumption good in period
t, and P
N
t
denotes the nominal price of one unit of nontradable consumption in period
t. It follows from this expression that the gross rate of consumer-price inflation, denoted
π
t
≡ P
t
/P
t−1
, is given by
π
t
=
¸
a
ξ
+ (1 −a)
ξ
p
t
1−ξ
a
ξ
+ (1 −a)
ξ
p
t−1
1−ξ

1
1−ξ

t
.
Because the relative price of nontradables, p
t
, is a stationary variable, it follows that under a
currency peg (i.e., when the central bank sets
t
= 1 at all times), the rate of inflation must
be approximately nil on average.
The low and stable rate of inflation induced by the currency peg comes at the cost of
poorer real macroeconomic performance. In particular, the currency peg causes unemploy-
ment, which ranges from 7 percent in the high-wage-rigidity case to about 0.25 percent in the
low-wage-rigidity case, and an elevated volatility of consumption, which reaches 5 percent
with high wage rigidity and 2 percent with low wage rigidity. The last column of table 2
shows that the welfare cost of a currency peg can be large. It shows that in the high-wage-
rigidity case, households require an increase of 5 percent in their consumption stream to feel
as happy as in the economy with optimal monetary policy. The welfare cost of a peg is also
sizable in the economy with intermediate wage rigidities, reaching 1 percent. When firms
are allowed to cut nominal wages by 40 percent per year or more (i.e., when γ is less than
or equal to 0.9), the economy behaves virtually as an economy with full wage flexibility. We
conclude that in the economy under study, the central bank faces a clear tradeoff between
inflation on the one hand, and unemployment and aggregate instability on the other hand.
Moreover, this tradeoff can involve large numbers for both inflation and unemployment for
relatively mild levels of downward nominal rigidities. For instance, we have shown that when
firms can costlessly cut nominal wages y up to twenty percent per year, the rate of inflation
ranges from 6 percent per year under the optimal exchange-rate policy to zero percent under
a peg, and structural unemployment ranges from zero under the optimal policy to 1.3 percent
under a currency peg.
In the present model, the employment-inflation tradeoff is trivially resolved in favor of
inflation. This is because, for simplicity, we have assumed that inflation is costless. However,
20
in a more realistic setting in which in secular price increases are costly, such as in models that
introduce a demand for liquidity or models with upwardly rigid product prices, the structural
inflationary pressures highlighted in this paper would give rise to a nontrivial resolution of
the employment-inflation tradeoff.
[TO BE CONTINUED]
21
References
Mendoza, Enrique G., and Vivian Z. Yue, “A Solution to the Disconnect between Country
Risk and Business Cycle Theories,” working paper, University of Maryland, April 2010.
Olivera, Julio H. G., “La Teor´ıa No Monetaria de la Inflaci´ on,” El Trimestre Econ´omico 27,
October-December 1960, 616-628.
Olivera, Julio H. G., “On Structural Inflation and Latin-American ‘Structuralism’,” Oxford
Economic Papers 16, November 1964, 321-332.
Reinhart, Carmen M., and Carlos A. V´egh, “Nominal interest rates, consumption booms,
and lack of credibility: A quantitative examination,” Journal of Development Economics
46, April 1995, 357-378.
Schmitt-Groh´e, Stephanie, and Mart´ın Uribe, “The Optimal Rate of Inflation,” Handbook
of Monetary Economics, edited by B. Friedman and M. Woodford, 2010 forthcoming.
Stockman, Alan C., and Linda L. Tesar, “Tastes and Technology in a Two-Country Model
of the Business Cycle: Explaining International Comovements,” American Economic
Review 85, March 1995, 168-185.
Tobin, James, “Inflation and Unemployment,” American Economic Review 62, March 1972,
1-18.
Uribe, Mart´ın, “Exchange-Rate-Based Inflation Stabilization: The Initial Real Effects of
Credible Plans,” Journal of Monetary Economics 39, June 1997, 197-221.
22

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