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Real and Monetary Disturbances in an Exchange-Rate Union

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  • Richard C. Marston
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    Abstract

    This paper investigates how a small country fares in an exchange-rate union if that country is subject to real and monetary disturbances originating at home and abroad. By joining a union, the country can fix the exchange rate between its currency and the currency of another country or countries. The paper asks whether or not fixing this exchange rate helps to modify the effects of disturbances on the domestic economy. This question is investigated within a model consisting of an aggregate demand equation dependent upon the terms of trade, an aggregate supply equation in which labor supply is responsive to the general price level, and a financial equation that determines the exchange rate of the domestic currency relative to one of two foreign currencies (the other being determined by triangular arbitrage) . Aggregate supply behavior varies depending upon whether wages respond to prices with a lag or are indexed to current changes in the general price level. Because the small country model cannot be used by itself to analyze the effects of foreign disturbances, the paper introduces models of two foreign countries with the same analytical structure as the domestic country model. Foreign disturbances are studied in two stages, first within the foreign model, then within the domestic model. The analysis shows that one of the most important factors determining the effects of the union is the degree of wage indexation in the domestic economy. The greater the degree of indexation, the less difference there is between output variation in the union and in a flexible regime. Apart from wage behavior, two other factors are important: the sources of the disturbances and the pattern of trade. Contrary to common belief, the case for a union is not necessarily strengthened if disturbances primarily originate outside the union and if the domestic country trades primarily with other members of the union.

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    File URL: http://www.nber.org/papers/w0705.pdf
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    Bibliographic Info

    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 0705.

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    Date of creation: Sep 1985
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    Publication status: published as Marston, Richard C. "Exchange Rate Unions as an Alternative to Flexible Rates: The Effects of Real and Monetary Disturbances." Exchange Rate Theoryand Practive, edited by J. F.O. Bilson & Richard C. Marston, pp. 407-437 and 441-442. Chicago: The University of Chicago Press, 1984.
    Handle: RePEc:nbr:nberwo:0705

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    References

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    1. Robert P. Flood & Nancy Peregrim Marion, 1980. "The Transmission of Disturbances under Alternative Exchange-Rate Regimeswith Optimal Indexing," NBER Working Papers 0500, National Bureau of Economic Research, Inc.
    2. Thomas Willett & Edward Tower, 1970. "Currency areas and exchange-rate flexibility," Review of World Economics (Weltwirtschaftliches Archiv), Springer, vol. 105(1), pages 48-65, September.
    3. Jeffrey Sachs, 1979. "Wage indexation, flexible exchange rates, and macro-economic policy," International Finance Discussion Papers 137, Board of Governors of the Federal Reserve System (U.S.).
    4. Fischer, Stanley, 1977. "Wage indexation and macroeconomics stability," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 5(1), pages 107-147, January.
    5. Marston, Richard C., 1980. "Cross country effects of sterilization, reserve currencies, and foreign exchange intervention," Journal of International Economics, Elsevier, vol. 10(1), pages 63-78, February.
    6. Gray, Jo Anna, 1976. "Wage indexation: A macroeconomic approach," Journal of Monetary Economics, Elsevier, vol. 2(2), pages 221-235, April.
    7. Richard C. Marston, 1980. "Exchange-Rate Unions and the Volatility of the Dollar," NBER Working Papers 0492, National Bureau of Economic Research, Inc.
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    Cited by:
    1. Richard C. Marston, 1981. "Wages, Relative Prices, and the Choice between Fixed and Flexible Exchange Rates," NBER Working Papers 0793, National Bureau of Economic Research, Inc.

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