Money- and Exchange-Rate-Based Disinflation in a Redux Model with Staggered Wage Setting

An analytical dynamic general equilibrium model of a small open economy with tradeable and nontradeable sectors is constructed. Workers have monopoly power and wage setting is staggered. Initially, the economy is in an inflationary steady state with a floating exchange rate. Money-based disinflation produces a short–run recession in both sectors, whereas exchange-rate-based stabilisation generates an initial boom in both. These results accord with the stylised facts. Moderation of wage inflation by forward-looking wage setters is the novel mechanism generating the boom under exchange-rate-based stabilisation. Longer run effects and effects on other variables are also discussed.