Pegs and Pain Stephanie Schmitt-Groh e Mart n Uribe Columbia - PowerPoint PPT Presentation

Pegs and Pain Stephanie Schmitt-Groh´ e Mart ´ ın Uribe Columbia University March 12, 2012 1

Motivation • History suggests that currency pegs are easy to adopt, but hard to maintain. • The Achilles’ Heel of Currency Pegs: The combination of downward nominal wage rigidity and a currency peg creates rigidity in real wages, which makes countries highly vulnerable to negative shocks. • Our question: How much extra unemployment and pain do currency pegs add to external crises? 2

Boom-Bust Cycle in Peripherical Europe: 2000-2011 Current Account / GDP Labor Cost Index, Nominal Unemployment Rate −2 110 14 13 −4 100 12 Index, 2008 = 100 −6 90 11 Percent Percent −8 80 10 9 −10 70 8 −12 60 7 −14 50 6 2002 2004 2006 2008 2010 2002 2004 2006 2008 2010 2002 2004 2006 2008 2010 Date Date Date Data Source: Eurostat. Data represents arithmetic mean of Bulgaria, Cyprus, Estonia, Greece, Lithuania, Latvia, Portugal, Spain, Slovenia, and Slovakia 3

Related Literature: Eichengreen and Sachs, 1985 (gold standard theory of great depression, empirical) Welfare cost of peg: Kollmann, 2002 (small open economy with sticky prices, 4 shocks, monopolistic competition, incomplete markets, welfare costs of pegs < 1%) Gal ´ ı and Monacelli, 2005 (small open economy with sticky prices, small welfare costs of pegs) 5

The Gold Standard Hypothesis (Eichengreen and Sachs, 1985) Countries that left gold early enjoyed much more rapid recoveries than those that stayed on gold. This difference in performance was associated with earlier reflation of price levels in the countries leaving gold Gold Bloc: France, Belgium, Netherland, Italy Sterling Bloc: (left gold early, 1931) : United Kingdom, Denmark, Finland, Sweden, Norway 6

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What the paper does: • Build a traded-nontraded good small open economy model with downward nominal wage rigidity and liability dollariza- tion. • Characterize aggregate dynamics under optimal exchange rate policy and under a currency peg. • Quantify the costs of currency pegs in terms of unemploy- ment and welfare. 8

Preview of Main Findings • Currency pegs are extremely painful. • They induce an average unemployment rate of 14 percent and lower aggregate consumption by 5 percent on average. • The median welfare costs of pegs is 4–10 percent of con- sumption. 9

A Model of unemployment due to downward nominal wage rigidity W t ≥ γW t − 1 W t = nominal wage rate in period t γ ≥ 0 degree of downward wage rigidity 10

Empirical Evidence on Downward Nominal Wage Rigidity — what is a plausible value for γ 11

Some Evidence that Nominal Wage Rigidity is One-Sided 12

Probability of Decline, Increase, or No Change in Nominal Wages Between Interviews U.S. data, SIIP panel 1986-1993, within-job changes Interviews One Year apart Males Females Decline 5.1% 4.3% Constant 53.7% 49.2% Increase 41.2% 46.5% Source: Gottschalk (2005) Note. Male and female hourly workers not in school, 18 to 55 at some point during the panel. All nominal-wage changes are within-job wage changes, defined as changes while working for the same employer. 13

Quarterly, 1996-99. Source: Barattieri, Basu, and Gottschalk (2010) 14

Evidence on the size of γ 15

Argentina 1996-2006 Nominal Exchange Rate (E t ) Unemployment Rate + Underemployment Rate 4 40 Pesos per U.S. Dollar 3 35 Percent 2 30 1 25 0 20 1996 1998 2000 2002 2004 2006 1996 1998 2000 2002 2004 2006 Year Year Nominal Wage (W t ) Real Wage (W t /E t ) 1.5 Pesos per Hour Index 1996=1 1 12 0.5 6 0 1996 1998 2000 2002 2004 2006 1996 1998 2000 2002 2004 2006 Year Year Memo: Average annual CPI inflation 1998-2001: -0.86% 16

Unemployment, Nominal Wages, and γ Evidence from the Eurozone Unemployment Rate Wage Growth Implied W 2011 Q 2 2008Q1 2011Q2 Value of W 2008 Q 1 Country γ (in percent) (in percent) (in percent) Bulgaria 6.1 11.3 43.3 1.028 Cyprus 3.8 6.9 10.7 1.008 Estonia 4.1 12.8 2.5 1.002 Greece 7.8 16.7 -2.3 0.9982 Lithuania 4.1 15.6 -5.1 0.996 Latvia 6.1 16.2 -0.6 0.9995 Portugal 8.3 12.5 1.91 1.001 Spain 9.2 20.8 8.0 1.006 Slovenia 4.7 7.9 12.5 1.009 Slovakia 10.2 13.3 13.4 1.010 Note. W is an index of nominal average hourly labor cost in manufacturing, construction, and services. Unemployment is the economy-wide unemployment rate. Source: EuroStat. 17

The Model 18

Traded and Nontraded Goods Traded goods, stochastic endowment: y T t Nontraded goods, produced with labor: y N = F ( h t ) t The relative price on nontradables: p t = P N t P T t Law of one price holds for tradables: P T t = P ∗ t E t Nominal exchange rate: E t Assume that P ∗ t = 1 19

Firms in the Nontraded Sector max p t F ( h t ) − w t h t , { h t } taking as given p t and w t , where w t ≡ W t /E t is the real wage in terms of tradables. Optimality condition (or the Supply of Nontradables): p t = W t /E t F ′ ( h t ) 20

The Supply of Nontraded Goods p W 0 /E 0 F ′ ( h ) h 21

E t ↑ : A Devaluation Shifts The Supply Schedule Down p W 0 /E 0 F ′ ( h ) W 0 /E 1 F ′ ( h ) h ( E 1 > E 0 ) 22

Households ∞ β t U ( c t ) � max E 0 { c T t ,c N t , d t +1 } t =0 subject to c t = A ( c T t , c N t ) t + w t h t + d t +1 c T t + p t c N t + d t = y T + φ t 1 + r t d t +1 ≤ ¯ d • Workers supply ¯ h hours inelastically, but may not be able to sell them all. They take h t ≤ ¯ h as given. • One first-order condition (Demand for Nontradables): A 2 ( c T t , c N t ) t ) = p t A 1 ( c T t , c N 23

The Demand for Nontraded Goods p A 2 ( c T 0 , F ( h ) ) A 1 ( c T 0 , F ( h ) ) h 24

A Contraction in Traded Absorption, c T t ↓ , Shifts the Demand for Nontradables Down and to the Left p A 2 ( c T 0 , F ( h ) ) A 1 ( c T 0 , F ( h ) ) A 2 ( c T 1 , F ( h ) ) A 1 ( c T 1 , F ( h ) ) h ( c T 1 < c T 0 ) 25

Disequilibrium in the Labor Market The following 3 conditions must hold at all times: W t ≥ γW t − 1 h t ≤ ¯ h � = 0 (¯ h − h t ) � W t − γW t − 1 26

Currency Pegs and Unemployment (here assume that γ = 1) p A 2 ( c T 0 , F ( h ) ) A 1 ( c T 0 , F ( h ) ) A 2 ( c T 1 , F ( h ) ) W 0 /E 0 A 1 ( c T 1 , F ( h ) ) A F ′ ( h ) p 0 B p PEG W 0 /E 1 C F ′ ( h ) p OPT h PEG h = h OPT ¯ h c T 1 < c T 0 (negative shock) and E 1 > E 0 (optimal devaluation) 27

Optimal Exchange-Rate Policy Set the (gross) devaluation rate, ǫ t = E t /E t − 1 , to eliminate un- employment: � � 1 , γW t − 1 /E t − 1 ǫ t ≡ max ω ( c T t ) where ω ( c T t ) denotes the full-employment real wage: t ) ≡ A 2 ( c T t , F (¯ h )) ω ( c T h )) F ′ (¯ ω ′ ( c T h ); t ) > 0 A 1 ( c T t , F (¯ Dynamics Under Optimal Exchange Rate Policy v OPT ( y T � U ( A ( c T h )) + β E t v OPT ( y T � t , F (¯ t , r t , d t ) = max t +1 , r t +1 , d t +1 ) { d t +1 ,c T t } subject to d t +1 ≤ ¯ d and t + d t +1 y T = d t + c T t 1 + r t 28

Currency Pegs Set the (gross) devaluation rate to unity: ǫ t = 1 . • Implied labor allocation  t ) ≥ γ W t − 1 ω ( c T ¯ = h if   E t − 1  h t A N ( c T t ,F ( h t )) t ,F ( h t )) F ′ ( h t ) = γ W t − 1 t ) < γ W t − 1 ω ( c T solves if  A T ( c T E t − 1 E t − 1   • Disequilibrium dynamics cannot be expressed as the solu- tion to a Bellman equation without additional state variables. • Solution Method: Iteration of disequilibrium conditions over the (discretized) 4-dimensional state space { y T t , r t , d t , w t − 1 } . 29

Calibration and Functional Forms U ( c ) = c 1 − σ − 1 1 − σ ξ a ( c T ) 1 − 1 ξ + (1 − a )( c N ) 1 − 1 � � ξ − 1 A ( c T , c N ) = ξ F ( h ) = h α Parameter Value Description γ 0.99 Degree of downward nominal wage rigidity (also 0.98-0.96) σ − 1 1/5 Intertemp. elast. subst. (Reinhart and V´ egh, 1995) 0.26 Share of tradables a 0.44 Intratemp. elast. subst. (Gonz´ alez-Rozada et al., 2004) ξ 0.75 Labor share in nontraded sector α ¯ h 1 Labor endowment β 0.9375 Quarterly subjective discount factor 30

The Driving Process: Estimate the following AR(1) system using Argentine data over the period 1983:Q1—2001:Q3:  ln y T  ln y T � � t − 1 t  + ǫ t , = A ln 1+ r t ln 1+ r t − 1  1+ r 1+ r Summary Statistics y T Statistic r Std. Dev. 12% 6%yr Serial Corr. 0.95 0.93 Corr( y T t , r t ) -0.86 Mean 1 12%yr 31

Traded Output in Argentina 1983:Q1-2008:Q3 0.2 0.15 0.1 0.05 0 ln y T t −0.05 −0.1 −0.15 −0.2 −0.25 1980 1985 1990 1995 2000 2005 2010 Note. Detrended and seasonally adjusted. 32

The Origin of a Crisis T Traded Output, y t 5 percent deviation from mean 0 −5 −10 −15 −20 −25 −10 −5 0 5 10 15 20 25 30 quarters since onset of crisis Annualized Interest Rate, r t percentage point deviation from mean 15 10 5 0 −5 −10 −5 0 5 10 15 20 25 30 quarters since onset of crisis 33