DP8275 | Pegs and Pain

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This paper quantifies the costs of adhering to a fixed-exchange-rate arrangement, such as a currency union, for emerging economies. To this end it develops a novel dynamic stochastic disequilibrium model of a small open economy with monetary nonneutrality due to downward nominal wage rigidity. In the model, a negative external shock causes persistent unemployment because the fixed exchange rate and downward wage rigidity stand in the way of real depreciation. In these circumstances, optimal exchange-rate policy calls for large devaluations. In a calibrated version of the model, a large contraction, defined as a two-standard-deviation decline in tradable output causes the unemployment rate to rise by more than 20 percentage points under a peg. The required devaluation under the optimal exchange-rate policy is more than 50 percent. The median welfare cost of a currency peg is shown to be enormous, about 10 percent of lifetime consumption. Adhering to a fixed exchange-rate arrangement is found to be more costly when initial fundamentals are characterized by high past wages, large external debt, high country premia, or unfavorable terms of trade.