Exchange-rate-based stabilization: Imperfect competition and supply-side effects

Abstract

This paper studies exchange-rate-based stabilization programs in the context of a dynamic general equilibrium model for a small open economy that incorporates imperfect competition, a backward-looking wage setting, and an endogenous labor supply. In contrast to previous results, the analysis shows that a permanent disinflation leads to a sustained expansion in the domestic sector and a slow inflation convergence. This study also shows that a temporary stabilization replicates a “boom-recession cycle”. These results suggest that a backward-looking wage setting and an endogenous labor supply are the key ingredients for reproducing the stylized facts of exchange-rate-based stabilization.