Working Paper: CEPR ID: DP8983
Authors: Stephanie Schmitt-Grohé; Martín Uribe
Abstract: The combination of a fixed exchange rate and downward nominal wage rigidity creates a real rigidity. In turn, this real rigidity makes the economy prone to involuntary unemployment during external crises. This paper presents a graphical analysis of alternative policy strategies aimed at mitigating this source of inefficiency. First- and second-best monetary and fiscal solutions are analyzed. Second-best solutions are prudential, whereas first-best solutions are not.
Keywords: Capital Controls; Currency Pegs; Downward Nominal 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 |
|---|---|
| Fixed exchange rates + Downward nominal wage rigidity (F31) | Real rigidity (D50) |
| Real rigidity (D50) | Involuntary unemployment (J64) |
| Fixed exchange rates + Downward nominal wage rigidity (F31) | Involuntary unemployment (J64) |
| Optimal devaluation policies (F31) | Full employment (J23) |
| Labor subsidies (J38) | Pareto optimal allocation (D61) |
| Labor subsidies (J38) | Employment levels (J23) |