Managing Currency Pegs

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 Classification: E31, E62, F41