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Abstract:
This paper conducts a quantitative examination of the hypothesis that uncertain
duration of currency pegs causes the sharp real appreciations and business
cycles that affect chronically countries using fixed exchange rates as an
instrument to stop high inflation. Numerical solutions of equilibrium dynamics
of a two-sector small open economy with incomplete markets show that uncertain
duration rationalizes the syndrome of exchange-rate-based stabilizations
without price or wage rigidities. Three elements of the model are critical for
these results: (a) a strictly-convex hazard rate function describing
time-dependent devaluation probabilities, (b) the wealth effects introduced by
incomplete insurance arkets, and (c) the supply-side effects introduced via
capital accumulation and elastic labor supply. Uncertain duration also entails
large welfare costs, compared to the perfect-foresight credibility framework,
although temporary disinflations are welfare-improving. The model's potential
empirical relevance is examined further by reviewing Mexico's post-war
experience with the collapse of six currency pegs.
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