UNEMPLOYMENT PERSISTENCE AND THE SUSTAINABILITY OF EXCHANGE RATE PEGS

Olli Castrén, Tuomas Takalo and Geoffrey Wood

Scottish Journal of Political Economy, 2010, vol. 57, issue 1, 85-102

Abstract: It is commonly thought that an open economy can accommodate output shocks through either exchange rate or real sector adjustments. We formalize this notion by incorporating unemployment persistence into a two‐sided escape clause model of currency crises. We show that unemployment persistence makes a currency peg more fragile and undermines the credibility of the monetary authority in a dynamic setting. The fragility is captured by a devaluation premium in expectations that increases the average inflation rate when the currency peg is more vulnerable to ‘busts’ than ‘booms’. This interaction between macroeconomic and microeconomic rigidities suggests that a policy reform can only be consistent if it renders either exchange rates or the economy more flexible.

Date: 2010
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https://doi.org/10.1111/j.1467-9485.2009.00508.x

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Persistent link: https://EconPapers.repec.org/RePEc:bla:scotjp:v:57:y:2010:i:1:p:85-102

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