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Wages, Relative Prices, and the Choice between Fixed and Flexible Exchange Rates

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  • Richard C. Marston
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    Abstract

    This paper reexamines the choice between fixed and flexible rates to take into account wage indexation and flexible prices. The model employed is of a small open economy faced by monetary and aggregate demand disturbances originating at ham and abroad. Aggregate supply behavior in this &el varies depending upon whether wages are set in one-period labor contracts or are indexed to current changes in the general price level, Two central conclusions emerge from the analysis. First, for all disturbances the difference in output variation between fixed and flexible rates is dependent upon the degree of wage indexation, being proportional to one minus the degree of wage indexation in the domestic economy. Thus the more highly indexed the economy, the less difference the choice of exchange rate regime makes to output variation, Secondly, the effect of foreign disturbances on the domestic economy depends as much on foreign wage and price behavior as domestic. If the rest of the world is fully indexed, flexible rates insulate the domestic country completely from foreign monetary disturbances, If the rest of the world is more highly indexed than the domestic country, then for high price elasticities at least, a flexible rate dampens the output variation associated with foreign demand disturbances.

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    Bibliographic Info

    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 0793.

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    Date of creation: Oct 1981
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    Publication status: published as Marston, Richard C. "Wages, Relative Prices, and the Choice between Fixed and Flexible Exchange Rates." Canadian Journal of Economics, Vol. XV, No. 1,(February 1982), pp. 87-103.
    Handle: RePEc:nbr:nberwo:0793

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    1. Flood, Robert P & Marion, Nancy Peregrim, 1982. "The Transmission of Disturbances under Alternative Exchange-Rate Regimes with Optimal Indexing," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 97(1), pages 43-66, February.
    2. Richard C. Marston, 1985. "Real and Monetary Disturbances in an Exchange-Rate Union," NBER Working Papers 0705, National Bureau of Economic Research, Inc.
    3. Gray, Jo Anna, 1976. "Wage indexation: A macroeconomic approach," Journal of Monetary Economics, Elsevier, Elsevier, vol. 2(2), pages 221-235, April.
    4. Sachs, Jeffrey, 1980. "Wages, Flexible Exchange Rates, and Macroeconomic Policy," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 94(4), pages 731-47, June.
    5. Brunner, Karl & Meltzer, Allan H., 1977. "Stabilization of the domestic and international economy," Carnegie-Rochester Conference Series on Public Policy, Elsevier, Elsevier, vol. 5(1), pages 1-6, January.
    6. Eaton, Jonathan & Turnovsky, Stephen J., 1982. "Effects of monetary disturbances on exchange rates with risk averse speculation," Journal of International Money and Finance, Elsevier, Elsevier, vol. 1(1), pages 21-37, January.
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    Cited by:
    1. Joshua Aizenman, 1983. "Modeling Deviations from Purchasing Power Parity (PPP)," NBER Working Papers 1066, National Bureau of Economic Research, Inc.
    2. Alesina, Alberto & Perotti, Roberto, 1995. "Taxation and redistribution in an open economy," European Economic Review, Elsevier, Elsevier, vol. 39(5), pages 961-979, May.
    3. Esteban Jadresic, 1998. "The Macroeconomic Consequences of Wage Indexation Revisited," IMF Working Papers 98/15, International Monetary Fund.
    4. Stephen J. Turnovsky, 1983. "Wage Indexation and Exchange Market Interventions in a Small Open Economy," Canadian Journal of Economics, Canadian Economics Association, Canadian Economics Association, vol. 16(4), pages 574-92, November.
    5. Richard C. Marston, 1982. "Real Wages and the Terms of Trade: Alternative Indexation Rules for an Open Economy," NBER Working Papers 1046, National Bureau of Economic Research, Inc.
    6. Rudiger Dornbusch, 1982. "Flexible Exchange Rates and Interdependence," NBER Working Papers 1035, National Bureau of Economic Research, Inc.
    7. Robert P. Flood & Robert J. Hodrick, 1986. "Money and the Open Economy Business Cycle: A Flexible Price Model," NBER Working Papers 1967, National Bureau of Economic Research, Inc.
    8. Aizenman, Joshua, 1985. "Wage Flexibility and Openness," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 100(2), pages 539-50, May.
    9. Joshua Aizenman & Jacob A. Frenkel, 1984. "Optimal Wage Indexation, Foreign-Exchange Intervention and Monetary Policy," NBER Working Papers 1329, National Bureau of Economic Research, Inc.
    10. Esteban Jadresic, 2002. "The Macroeconomic COnsequences of Wage Indexation Revisited," Central Banking, Analysis, and Economic Policies Book Series, Central Bank of Chile, in: Fernando Lefort & Klaus Schmidt-Hebbel & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Serie (ed.), Indexation, Inflation and Monetary Policy, edition 1, volume 2, chapter 8, pages 207-258 Central Bank of Chile.
    11. Lai, Ching-chong & Chang, Juin-jen & Chang, Wen-ya, 2001. "Currency devaluation in an open-shop union," International Review of Economics & Finance, Elsevier, Elsevier, vol. 10(1), pages 61-74.
    12. Ernst Fehr & Franz Hof, 1994. "Wage bargaining and shock sensitivity of a small open economy," Journal of Economics, Springer, Springer, vol. 59(3), pages 259-286, October.
    13. Kim, Yoonbai & Ying, Yung-Hsiang, 2007. "An empirical assessment of currency devaluation in East Asian countries," Journal of International Money and Finance, Elsevier, Elsevier, vol. 26(2), pages 265-283, March.
    14. Chang, Juin-Jen & Lai, Ching-Chong & Chang, Wen-Ya, 1999. "The Mundell proposition with efficient wage-employment bargaining," Journal of Macroeconomics, Elsevier, Elsevier, vol. 21(4), pages 765-784.
    15. Jürgen Hagen & Manfred Neumann, 1990. "Relative price risk in an open economy with fixed and flexible exchange rates," Open Economies Review, Springer, Springer, vol. 1(3), pages 269-289, October.
    16. Joshua Aizenman, 1984. "Optimal Wage Re-Negotiation," NBER Working Papers 1279, National Bureau of Economic Research, Inc.

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