UNEMPLOYMENT PERSISTENCE AND THE SUSTAINABILITY OF EXCHANGE RATE PEGS |
| |
Authors: | Olli Castrén Tuomas Takalo Geoffrey Wood |
| |
Institution: | 1. DG Economics, European Central Bank;2. Bank of Finland and School of Business and Economics, University of Jyv?skyl?;3. Cass Business School, City University |
| |
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. |
| |
Keywords: | |
|