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.
|
