Price and Output Effects of Monetary and Fiscal Policy under Flexible Exchange Rates: Comment on Argy and Salop

Abstract

N A WELL-KNOWN CONTRIBUTION to this journal, Argy and Salop (1979) analyzed the effects of monetary and fiscal policy on the price level and real output when exchange rates are flexible, paying particular attention to the consequences of real wage rigidity. This comment concerns one of their conclusions in particular: that if the consumption real wage is completely rigid, the balanced-budget multiplier is negative. Moreover, in their model the overall price level (the consumer price index) moves in a direction opposite to that of real output for given money supply, so that a balanced-budget reduction in government spending would actually raise output and lower the price level. Balancedbudget reductions in government expenditure therefore seem to be an attractive policy option. This result, however, may not be robust because it depends on the assumption that absorption (measured in units of domestic output) decreases as the terms of trade improve-the Laursen-Metzler effect (Laursen and Metzler (1950)). Recent work on this effect (for example, Obstfeld (1982) and Svensson and Razin (1983)) implies that, on the contrary, absorption in units of domestic output may rise with the terms of trade. I show below that if there is no Laursen-Metzler effect, the balanced-budget multiplier can take either sign; this conclusion is reinforced if the Laursen-Metzler effect has the unconventional sign suggested by Obstfeld.