Wages, Flexible Exchange Rates, and Macroeconomic Policy

Abstract

In an open economy with a floaLing exchange rate, the efficacy of fiscal and monetary policy depends fundamentally on the wage-setting pnxiess. In the canonical models of Mundell and Fleming, monetary expansion raises output via an exchange rate depreciation, while fiscal expansion has no output effect. These results hold only when real wages can be altered by exchange rate movements; if the real wage is fixed, the Mundell-Fleming ranking of policy is reversed. This paper explores the interaction of wages and policy in short- and long-run models, under the assumptions of perfect foresight and world capital mobility. After seven years of floating exchange rates, the implications of Hexible rates for countercyclical macroeconomic policy remain in douht. The traditional view, following the pioneering work of Mundell 1196;?) and Fleming [1962] (henceforth M-F), is that expansionary monetary policy, hy inducing depreciation ofthe real exchange rate, is effective in raising output in a small, underemployed economy. Fiscal policy, on the other hand, is seen as less effective. In the standard analysis, a rise in government spending leads to appreciation and crowding-out of net exports. An alternative view of flexihle rates, set forth in the full-employment models of glohal monetarism, maintains that a money supply expansion can change only the exchange rate and price level, but not output and employment. While an increase in money causes depreciation ofthe nominal exchange rate, the domestic price level rises to offset the competitive gain envisaged in the M-F model. The alternative view has had less to say on the effects of fiscal policy and on the general question of prolonged unemployment. Both views of monetary policy have adherents, and there is evidence, in different countries and at different times, to support each. Their appropriateness, I shall argue here, depends crucially on the nature of the wage-determination process. The M-F model (in an extended form) requires that nominal exchange-rate changes alter the real wage.^ Implicit is an underlying view, going hack to Keynes,