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

This paper studies exchange-rate-based stabilization programs in the contex t of a model of a small open economy where labor supply is endogenous. Agen ts derive utility from both consumption and leisure. In environments where consumption is subject to a cash-in-advance constraint, a cut in the rate o f devaluation lowers the nominal interest rate and hence alters the optimal mix of consumption and leisure. The paper shows that in the presence of ad justment costs of investment, a perfectly credible cut in the devaluation r ate causes, simultaneously, a consumption and output boom, a cumulative cur rent deficit, a sustained real appreciation of the domestic currency and an increase in labor supply over time. It is also shown that an imperfectly c redible stabilization program in this environment would have effects simila r to the perfectly credible program bur generate richer dynamics such as an initial boom in output followed by a recession which begins prior to the e nd of the program. The model has clear welfare implications in that permane nt reductions in inflation are unambiguously welfare enhancing. (C) 2001 El sevier Science B.V. All rights reserved.