Labour market reform and the sustainability of exchange rate pegs

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Title: Labour market reform and the sustainability of exchange rate pegs
Author: Castrén, Olli ; Takalo, Tuomas ; Wood, Geoffrey
Organization: Suomen Pankki
Series: Suomen Pankin keskustelualoitteita
Series number: 22/2004
Year of publication: 2004
Publication date: 16.11.2004
Published in: Published in Scottish Journal of Political Economy, Volume 57, No. 1, February 2010: 85-102
Pages: 35 s.
Keywords: valuuttapolitiikka; valuuttakurssit; työmarkkinat; joustot; uudistukset; työttömyys;
JEL: E42; F33; D84
Abstract: It is commonly thought that an open economy can accommodate output shocks through either exchange rate or real sector adjustments.We formalise this notion by incorporating labour market rigidities into an 'escape clause' model of currency crises.We show that the absence of structural reform 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 labour markets flexible. Key words: exchange rate policy, labour market flexibility, structural reform JEL classification numbers: E42, F33, D84

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