Union Wage Setting and Exchange Rate Policy

Abstract

The performance of an optimally managed float is compared with that of a credibly fixed exchange rate in a small open‐economy framework where wages are set by a monopoly union. Two key results emerge. First, a sufficient condition for the managed float to outperform a fixed rate is that the union be no less inflation‐averse than society. Second, introducing an inflation target into the central bank's loss function ensures the superiority of the managed float regardless of the weight attached to inflation by the union. Both results reflect the sensitivity of the union mark‐up to the policy regime.