The Potential Effects of Unemployment and Inflation on Currency Crisis under Fixed Exchange Rate System in a Small Open Economy: Jordan Case

Abstract

The paper investigates the potential effects of macroeconomic variables on currency deviations as indicator for currency crisis under fixed exchange rate system in a small open economy of Jordan; where larger currency deviation of the real exchange rate from the nominal exchange rate implies depreciation of Jordanian dinar and potentially may lead to currency crisis. Running ARDL regressions and DOLS estimator for robustness and sensitivity checks; the results indicates that high and persistent unemployment rates and high inflation rates have high long-run multiple significant effects on increasing currency deviations. Control variables such as reserves growth, trade openness, and terms of trades have negative significant in reducing currency deviations but their long-run multipliers shows small effects particularly reserve, implying temporary remedy role of reserves in reducing currency deviations; but the results of domestic and external debts, remittances and grants are found to be insignificant. The paper concludes that high unemployment rates may lead to currency crisis as predicted by Obstfeld (1996) model; in addition the multiple costs of high inflation and unemployment rates outweigh the benefits from reserves growth, trade openness, terms of trade that may lead to currency crisis. The results of this paper provides a guiding tool to the monetary authorities and policymakers in Jordan of the key macroeconomic variables that affects the Jordan's domestic currency, which needs to be considered or maintained in the design of an appropriate ER policy to avoid future currency crisis.

Keywords: RER, NER, CURRDC, Currency Crisis, Unemployment, Inflation