Working Paper: NBER ID: w18031
Authors: Stephanie Schmitt-Grohe; Martin 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 in this model 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; fixed exchange rates; unemployment; welfare
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) | Increased unemployment (J64) |
| Negative pecuniary externality (D62) | Overborrowing (H74) |
| Increased unemployment (J64) | Involuntary unemployment due to downward nominal wage rigidity (J64) |
| Optimal capital control policies (F38) | Mitigate negative effects of pegging nominal exchange rate (F31) |
| Optimal capital control policies (F38) | Increase welfare (I38) |
| Optimal capital control policies (F38) | Stabilize consumption and employment (E20) |