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Optimal Exchange-Rate Targeting with Large Labor Unions

Listed author(s):
  • Vincenzo Cuciniello

    ()

    (Chair of International Finance, Ecole Polytechnique Federale de Lausanne (EPFL), Switzerland)

  • Luisa Lambertini

    ()

    (Chair of International Finance, Ecole Polytechnique Federale de Lausanne (EPFL), Switzerland)

We study whether monetary policy should target the exchange rate in a two-country model with non-atomistic wage setters, non-traded goods and different degrees of exchange-rate pass through. Commitment to an exchange rate target reduces the labor market distortion. Large labor unions anticipate that higher wages depreciate the exchange rate, which triggers an increase in the interest rate and restrain wage demands. However, reduced exchange rate flexibility worsens the distortion stemming from preset pricing. Targeting the nominal exchange rate will be optimal when the labor market distortion is larger than the preset-pricing one. This result arises with cooperation both under producer and local currency pricing, even though the optimal degree of exchange-rate targeting is higher under local currency pricing. In the Nash equilibrium, the terms-of-trade effect raises optimal wage mark-ups thereby reducing the optimal weight on the exchange rate target. The terms-of-trade effect is stronger as openness and substitutability among Home and Foreign goods increase.

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File URL: http://infoscience.epfl.ch/record/140489/files/CFP2009_01.pdf
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Paper provided by Center for Fiscal Policy, Swiss Federal Institute of Technology Lausanne in its series Working Papers with number 200901.

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Length: 36 pages
Date of creation: May 2009
Handle: RePEc:cif:wpaper:200901
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