Research Discussion Papers, Bank of Finland
No 22/2004:
Labour market reform and the sustainability of exchange rate pegs
Olli Castrén ()
, Tuomas Takalo ()
and Geoffrey Wood ()
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.
Keywords: exchange rate policy; labour market flexibility; structural reform; (follow links to similar papers)
JEL-Codes: D84; E42; F33; (follow links to similar papers)
40 pages, October 13, 2004
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