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Labor Market Dynamics after Nominal Devaluations

Dec 2015
Working Paper
16-013
By  Andres Drenik

This paper studies two channels through which exchange rate policy affects the real economy. First, if nominal wages do not decrease during a recession, a nominal devaluation of the currency--as opposed to a fixed exchange rate --reduces unemployment by lowering wages in real terms. However, if not all wages are equally rigid, sectoral labor markets respond differently under different exchange rate regimes and redistributive effects arise. Second, nominal devaluations can have an effect on the real value of nominal asset positions. The desirability of a nominal devaluation is analyzed in the context of a quantitative small open economy model. The model features heterogeneous workers and sectoral labor markets that differ in the degree of nominal rigidities. Using data from Argentina, I estimate the model to match aggregate and worker-level moments regarding labor market choices. The model predicts that fixed exchange rate regimes reduce employment and welfare during a recession. A devaluation that does not affect the real value of workers' nominal positions improves the overall well-being of workers, but entails a redistribution of welfare across certain groups of workers. Revaluation effects can be strong enough to overcome the labor market gain of a nominal devaluation.

Publication Keywords: 
Currency devaluation
heterogeneous nominal wage rigidity
heterogeneous workers