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Wage Indexation and Exchange Market Interventions in a Small Open Economy

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  • Stephen J. Turnovsky

Abstract

The analysis of this paper stresses the interdependence between wage indexation on the one hand, and exchange market intervention on the other,as tools of'macroeconomic stabilization policy in a small open economy subject to stochastic disturbances. It is shown how the choice of eitherpolicy instrument impinges on the effectiveness of the other. In particular,if the domestic money wage is fully indexed to some weighted average of the domestic and foreign price levels, then irrespective of what that chosen weight may be, exchange market intervention is rendered totally ineffective insofar as the stabilization of the real part of the domestic economy is concerned. Likewise, if the monetary authority intervenes in the exchange market so as to exactly accommodate for nominal movements in the demand for money, thereby rendering the excess demand for money dependent only upon real variables, then any form of wage indexation is totally ineffective for the stabilization of the real part of the system. In either polar case, the respective instrument can stabilize the domestic price level. Alternative combinations of policy for the stabilization for domestic and foreign disturbances are considered.
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Suggested Citation

  • Stephen J. Turnovsky, 1983. "Wage Indexation and Exchange Market Interventions in a Small Open Economy," Canadian Journal of Economics, Canadian Economics Association, vol. 16(4), pages 574-592, November.
  • Handle: RePEc:cje:issued:v:16:y:1983:i:4:p:574-92
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    1. Boyer, Russell S, 1978. "Optimal Foreign Exchange Market Intervention," Journal of Political Economy, University of Chicago Press, vol. 86(6), pages 1045-1055, December.
    2. Karni, Edi, 1983. "On Optimal Wage Indexation," Journal of Political Economy, University of Chicago Press, vol. 91(2), pages 282-292, April.
    3. Henderson, Dale W, 1979. "Financial Policies in Open Economies," American Economic Review, American Economic Association, vol. 69(2), pages 232-239, May.
    4. 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.
    5. Gray, Jo Anna, 1976. "Wage indexation: A macroeconomic approach," Journal of Monetary Economics, Elsevier, vol. 2(2), pages 221-235, April.
    6. Brock, William A, 1974. "Money and Growth: The Case of Long Run Perfect Foresight," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 15(3), pages 750-777, October.
    7. Robert P. Flood & Nancy Peregrim Marion, 1982. "The Transmission of Disturbances under Alternative Exchange-Rate Regimes with Optimal Indexing," The Quarterly Journal of Economics, Oxford University Press, vol. 97(1), pages 43-66.
    8. Cox, W. Michael, 1980. "Unanticipated money, output, and prices in the small economy," Journal of Monetary Economics, Elsevier, vol. 6(3), pages 359-384, July.
    9. Richard C. Marston, 1982. "Wages, Relative Prices and the Choice between Fixed and Flexible Exchange Rates," Canadian Journal of Economics, Canadian Economics Association, vol. 15(1), pages 87-103, February.
    10. Long, John B, Jr & Plosser, Charles I, 1983. "Real Business Cycles," Journal of Political Economy, University of Chicago Press, vol. 91(1), pages 39-69, February.
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    Cited by:

    1. Joshua Aizenman, 1988. "Monopolistic Competition and Labor Market Adjustment in the Open Economy," NBER Chapters,in: Misalignment of Exchange Rates: Effects on Trade and Industry, pages 169-194 National Bureau of Economic Research, Inc.
    2. Guender, Alfred V., 2008. ""Leaning with the wind"? An open-economy example," Journal of Macroeconomics, Elsevier, vol. 30(3), pages 941-964, September.
    3. Kim Kyung Soo, 2000. "Foreign Exchange Intervention For Internal Balance," International Economic Journal, Taylor & Francis Journals, vol. 14(4), pages 59-75.
    4. Michael B. Devereux & Charles Engel, 2001. "The Optimal Choice of Exchange Rate Regime: Price-Setting Rules and Internationalized Production," NBER Chapters,in: Topics in Empirical International Economics: A Festschrift in Honor of Robert E. Lipsey, pages 163-194 National Bureau of Economic Research, Inc.
    5. Charles Engel, 2001. "Optimal exchange rate policy: the influence of price setting and asset markets," Proceedings, Federal Reserve Bank of Cleveland, pages 518-547.
    6. Kilponen, Juha & Mayes, David & Vilmunen, Jouko, 1999. "Labour Market Flexibility in Northern Europe," ERSA conference papers ersa99pa088, European Regional Science Association.
    7. Joshua Aizenman, 1992. "Exchange Rate Flexibility, Volatility, and the Patterns of Domestic and Foreign Direct Investment," NBER Working Papers 3953, National Bureau of Economic Research, Inc.
    8. Esteban Jadresic, 1998. "The Macroeconomic Consequences of Wage Indexation Revisited," IMF Working Papers 98/15, International Monetary Fund.
    9. Flood, Robert P. & Hodrick, Robert J., 1986. "Real aspects of exchange rate regime choice with collapsing fixed rates," Journal of International Economics, Elsevier, vol. 21(3-4), pages 215-232, November.
    10. Alfred Guender, 2005. "On discretion versus commitment and the role of the direct exchange rate channel in a forward-looking open economy model," International Economic Journal, Taylor & Francis Journals, vol. 19(3), pages 355-377.
    11. Guender, Alfred V. & Tam, Julie, 2004. "On the performance of nominal income targeting as a strategy for monetary policy in a small open economy," Journal of International Money and Finance, Elsevier, vol. 23(2), pages 143-163, March.
    12. Christian Broda, 2002. "Terms of trade and exchange rate regimes in developing countries," Staff Reports 148, Federal Reserve Bank of New York.
    13. Mayes, David G. & Vilmunen, Jouko, 1999. "Unemployment in a small open economy : Finland and New Zealand," Research Discussion Papers 10/1999, Bank of Finland.
    14. Esteban Jadresic, 2002. "The Macroeconomic COnsequences of Wage Indexation Revisited," Central Banking, Analysis, and Economic Policies Book Series,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.
    15. Joshua Aizenman, 1991. "Foreign Direct Investment, Productive Capacity and Exchange Rate Regimes," NBER Working Papers 3767, National Bureau of Economic Research, Inc.
    16. Esteban Jadresic, 1998. "The Macroeconomic Consequences of Wage Indexation Revisited," Working Papers Central Bank of Chile 35, Central Bank of Chile.
    17. Michael B. Devereux & Charles Engel, 1998. "Fixed vs. Floating Exchange Rates: How Price Setting Affects the Optimal Choice of Exchange-Rate Regime," NBER Working Papers 6867, National Bureau of Economic Research, Inc.
    18. Jose A. Lopez & Mark M. Spiegel, 2002. "Financial structure and macroeconomic performance over the short and long run," Pacific Basin Working Paper Series 2002-05, Federal Reserve Bank of San Francisco.
    19. Broda, Christian, 2004. "Terms of trade and exchange rate regimes in developing countries," Journal of International Economics, Elsevier, vol. 63(1), pages 31-58, May.
    20. Kotilainen, Markku, . "Exchange Rate Unions: A Comparison with Currency Basket and Floating Rate Regimes," ETLA A, The Research Institute of the Finnish Economy, number 21.
    21. Froyen, Richard & Guender, Alfred, 2000. "Alternative Monetary Policy Rules for Small Open Economies," Review of International Economics, Wiley Blackwell, vol. 8(4), pages 721-740, November.

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