Thursday, July 19, 2012

Fixed Exchange Rates: Better Close That Capital Account

In the latest round of research from the NBER, this paper describes some “surprising” results (abstract):

Pegs, Downward Wage Rigidity, and Unemployment: The Role of Financial Structure
Stephanie Schmitt-Grohé, Martín Uribe

This paper studies the relationship between financial structure and the welfare consequences of fixed exchange rate regimes in small open emerging economies with downward nominal wage rigidity. The paper presents two surprising results. First, a pegging economy might be better off with a closed than with an open capital account. Second, the welfare gain from switching from a peg to the optimal (full-employment) monetary policy might be larger in financially open economies than in financially closed ones.

Personally, I’m not sure the results should be considered surprising or paradoxical – anybody who’s followed the empirical research into international currency crises shouldn’t miss the correlation between financial and capital account liberalisation, pegged exchange rates and financial crises.

On the other hand, what this paper provides is some really sound theoretical underpinnings (with micro-foundations no less) for the phenomenon. That makes it worth bookmarking for that reason alone. At the risk of over-generalising however, you can summarise the results as:

  1. If you want a fixed exchange rate, its better (and safer) to close the capital account (i.e. restrict the free-flow of money and funds that cross your borders e.g. via limits on foreign exchange transactions, withholding taxes, currency exports and imports);
  2. If you already have an open capital account, a floating exchange rate is the better policy option, and vice-versa.

Technical Notes:

Schmitt-Grohé, Stephanie & Martín Uribe, "Pegs, Downward Wage Rigidity, and Unemployment: The Role of Financial Structure", NBER Working Paper No. 18223, July 2012


  1. Don't we already know this from the Impossible Trinity?

  2. The trilemma, yes. I think they just reinvented the wheel, albeit in a rather novel way.