An Investigation into the Achilles' Heel of Currency Pegs

National Science Foundation, SES-1061711
Principal Investigator: Stephanie Schmitt-Grohe


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.