Exchange rate based stabilizations under real frictions: The role of endogenous labor supply

Abstract

This paper studies exchange-rate-based stabilization programs in the context of a model of a small open economy where labor supply is endogenous. Agents derive utility from both consumption and leisure. In environments where consumption is subject to a cash-in-advance constraint, a cut in the rate of devaluation lowers the nominal interest rate and hence alters the optimal mix of consumption and leisure. The paper shows that in the presence of adjustment costs of investment, a perfectly credible cut in the devaluation rate causes, simultaneously, a consumption and output boom, a cumulative current deficit, a sustained real appreciation of the domestic currency and an increase in labor supply over time. It is also shown that an imperfectly credible stabilization program in this environment would have effects similar to the perfectly credible program but generate richer dynamics such as an initial boom in output followed by a recession which begins prior to the end of the program. The model has clear welfare implications in that permanent reductions in inflation are unambiguously welfare enhancing.