Working Paper: CEPR ID: DP8961
Authors: Stephanie Schmitt-Grohé; Martín Uribe
Abstract: This paper shows that in a small open economy model with downward nominal wage rigidity pegging the nominal exchange rate creates a negative pecuniary externality. This peg-induced externality is shown to cause unemployment, overborrowing, and depressed levels of consumption. The paper characterizes the optimal capital control policy and shows that it is prudential in nature. For it restricts capital inflows in good times and subsidizes external borrowing in bad times. Under plausible calibrations of the model, this type of macro prudential policy is shown to lower the average unemployment rate by 10 percentage points, reduce average external debt by more than 50 percent, and increase welfare by over 7 percent of consumption per period.
Keywords: capital controls; currency pegs; downward wage rigidity; pecuniary externality
JEL Codes: E31; E62; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Pegging the nominal exchange rate (F31) | Negative pecuniary externality (D62) |
| Negative pecuniary externality (D62) | Rising unemployment during economic contractions (J64) |
| Optimal capital control policy (F38) | Reduce average unemployment rate (J68) |
| Optimal capital control policy (F38) | Decrease average external debt (F34) |
| Optimal capital control policy (F38) | Increase welfare (I38) |
| Downward nominal wage rigidity (J31) | Prevents real wages from adjusting downward during downturns (E24) |