This project is motivated by the recent economic turmoil in the Eurozone originating from adjustment problems in a number of emerging-market members, including Greece, Portugal, Ireland, and several Baltic states. A major contributing factor to the economic problems of emerging countries in the Eurozone is that currency pegs 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. Such shocks produce a contraction in domestic aggregate demand. To maintain full employment, the relative price of nontradables must fall, that is, the domestic currency must depreciate in real terms, producing an expenditure switch away from tradables and toward nontradables. In turn, the required real depreciation may occur via either a nominal devaluation of the domestic currency or a fall in nominal prices or both. The currency peg (or membership in a currency union) 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. The PI's refer to this phenomenon as the Achilles' heel of currency pegs. The aim of this project is (a) to build a model of the Achilles' heel of currency pegs. This part of the project plans to deliver a substantial methodological contribution by laying out the foundations of a dynamic stochastic disequilibrium model with downwardly rigid nominal wages. The model will feature a nontrivial interplay between exchange-rate policy and involuntary unemployment; (b) to characterize optimal monetary policy in economies that suffer from the Achilles' heel of currency pegs. This part of the project has the potential to deliver a theory of positive inflation targets (or structural inflation) of the size observed in actual economies, a result that is missing from the existing literature; (c) to study the role of fiscal policy in ameliorating the costs of currency pegs. This issue is particularly important because for many Eurozone members there may exist significant costs of abandoning the peg unrelated to stabilization policy, thereby placing countercyclical fiscal policy at center stage; and (d) to investigate the role of international capital market structure for the fragility of currency pegs. In this regard, we propose to analyze the effect of currency pegs on the probability of default, on the size of the country premium, and on the amount of debt a country can support. The dynamic stochastic disequilibrium model put forth in this proposal has the potential to rationalize the stylized fact, established in Reinhart and Rogoff (2010), that historically sovereign default and devaluations go hand in hand in emerging economies. Broader Impact: By shedding light on the consequences of currency pegs for unemployment, fiscal policy, and sovereign default, our proposed project aims to enhance the economic analysis conducted in private and public institutions concerned with the design of monetary and fiscal policy.

Project Report

Award 1061711 resulted in the following papers. The first major contribution of the Project was to build a model of the Achilles' heel of currency pegs. The model features a nontrivial interplay between exchange-rate policy and involuntary unemployment; Specifically, we developed a theoretical model of a small open dynamic stochastic economy with downward nominal wage rigidity. In the model, all agents are price takers, that is, firms are price takers and workers are price takers. Combining this feature of the model with the assumption of downward nominal wage rigidity, results in an economy with occasionally binding wage constraints. When the downward wage rigidity is binding, then involuntary unemployment emerges. The model was introduced in Schmitt-Grohe and Uribe, ``Pegs and Pain,'' NBER Working Paper No. 16847, 2011. In that paper we also review existing evidence on downward nominal wage ridigity and provide new empirical evidence in the support of downward wage rigidity in emerging markets. We also discuss the ability of fiscal policy to ease the pain induced by pegs. In Stephanie Schmitt-Grohé and Martín Uribe, ``Pegs and Pain,'' NBER Working Paper No. 16847, we further characterize optimal monetary policy and compute the welfare costs of currency pegs. Specifically, we identify a disconnect between historical and model-based assessments of the costs of currency pegs due to nominal rigidities. While the former attribute major contractions and massive unemployment to currency pegs, the latter find miniscule welfare losses. That paper reconciles these two assessments. Importantly, the model departs from existing sticky wage models in the Calvo-Rotemberg tradition in that employment is not always demand determined. This departure creates an endogenous connection between macroeconomic volatility and the average level of unemployment and in this way opens the door to large welfare gains from stabilization policy. In a calibrated version of the model, an external crisis, defined as a two-standard-deviation decline in tradable output and a two-standard-deviation increase in the country interest rate premium, causes the unemployment rate to rise by more than 20 percentage points under a peg. Currency pegs are shown to be highly costly also during regular business-cycle fluctuations. The median welfare cost of a currency peg is 4 and 10 percent of consumption per period. In Stephanie Schmitt-Grohé and Martín Uribe, ``Managing Currency Pegs,'' NBER Working Paper No. 18092, 2012, we demonstrate that combination of a fixed exchange rate and downward nominal wage rigidity creates a real rigidity. In turn, this real rigidity makes the economy prone to involuntary unemployment during external crises. The paper presents a graphical analysis of alternative monetary and fiscal policy strategies aimed at mitigating this source of inefficiency. First- and second-best monetary and fiscal solutions are analyzed. Second-best solutions are found to be prudential, whereas first-best solutions are not. In Stephanie Schmitt-Grohé and Martín Uribe, ``Prudential Policy for Peggers,'' NBER Working Paper No. 18031, 2012, we show that in a small open economy model with downward nominal wage rigidity pegging the nominal exchange rate creates a negative pecuniary externality. This peg-induced externality is shown to cause unemployment, overborrowing, and depressed levels of consumption. The paper characterizes the optimal capital control policy in this model and shows that it is prudential in nature. For it restricts capital inflows in good times and subsidizes external borrowing in bad times. Under plausible calibrations of the model, this type of macro prudential policy is shown to lower the average unemployment rate by 10 percentage points, reduce average external debt by more than 50 percent, and increase welfare by over 7 percent of consumption per period. In Stephanie Schmitt-Grohé and Martín Uribe, ``Pegs, Downward Wage Rigidity, and Unemployment: The Role of Financial Structure, '' NBER Working Paper No. 18223, 2012, we study the relationship between financial structure and the welfare consequences of fixed exchange rate regimes in small open emerging economies with downward nominal wage rigidity. The paper presents two surprising results. First, a pegging economy might be better off with a closed than with an open capital account. Second, the welfare gain from switching from a peg to the optimal (full-employment) monetary policy might be larger in financially open economies than in financially closed ones. In Na, Schmitt-Grohé, Uribe, and Yuem ``A Model of the Twin Ds: Optimal Default and Devaluation,'' NBER Working Paper No. 20314, 2014, we characterize jointly optimal default and exchange-rate policy. The theoretical environment is a small open economy with downward nominal wage rigidity as first introduced in ``Pegs and Pain'' and limited enforcement of international debt contracts as in Eaton and Gersovitz (1981). It is shown that under optimal policy default is accompanied by large devaluations. At the same time, under fixed exchange rates, optimal default takes place in the context of large involuntary unemployment. Fixed- exchange-rate economies are found to be able to support less external debt than economies with optimally floating rates.

National Science Foundation (NSF)
Division of Social and Economic Sciences (SES)
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Georgia Kosmopoulou
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Columbia University
New York
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