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

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  • Richard C. Marston

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.

Suggested Citation

  • 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.
    • Handle: RePEc:nbr:nberwo:0793
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    References listed on IDEAS

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    1. Gray, Jo Anna, 1976. "Wage indexation: A macroeconomic approach," Journal of Monetary Economics, Elsevier, vol. 2(2), pages 221-235, April.
    2. Richard C. Marston, 1981. "Real and Monetary Disturbances in an Exchange-Rate Union," NBER Working Papers 0705, National Bureau of Economic Research, Inc.
    3. 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.
    4. Brunner, Karl & Meltzer, Allan H., 1977. "Stabilization of the domestic and international economy," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 5(1), pages 1-6, January.
    5. Eaton, Jonathan & Turnovsky, Stephen J., 1982. "Effects of monetary disturbances on exchange rates with risk averse speculation," Journal of International Money and Finance, Elsevier, vol. 1(1), pages 21-37, January.
    6. Jeffrey Sachs, 1980. "Wages, Flexible Exchange Rates, and Macroeconomic Policy," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 94(4), pages 731-747.
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    1. 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.
    2. 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.
    3. Joshua Aizenman, 1984. "Optimal Wage Re-Negotiation," NBER Working Papers 1279, National Bureau of Economic Research, Inc.
    4. Joshua Aizenman, 1985. "Wage Flexibility and Openness," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 100(2), pages 539-550.
    5. Aizenman, Joshua, 1984. "Modeling Deviations from Purchasing Power Parity (PPP)," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 25(1), pages 175-191, February.
    6. Mr. Esteban Jadresic, 1998. "The Macroeconomic Consequences of Wage Indexation Revisited," IMF Working Papers 1998/015, International Monetary Fund.
    7. Aizenman, Joshua & Frenkel, Jacob A, 1985. "Optimal Wage Indexation, Foreign Exchange Intervention, and Monetary Policy," American Economic Review, American Economic Association, vol. 75(3), pages 402-423, June.
    8. 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.
    9. Jürgen Hagen & Manfred Neumann, 1990. "Relative price risk in an open economy with fixed and flexible exchange rates," Open Economies Review, Springer, vol. 1(3), pages 269-289, October.
    10. Alesina, Alberto & Perotti, Roberto, 1995. "Taxation and redistribution in an open economy," European Economic Review, Elsevier, vol. 39(5), pages 961-979, May.
    11. 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.
    12. Rudiger Dornbusch, 1982. "Flexible Exchange Rates and Interdependence," NBER Working Papers 1035, National Bureau of Economic Research, Inc.
    13. Chang, Juin-Jen & Lai, Ching-Chong & Chang, Wen-Ya, 1999. "The Mundell proposition with efficient wage-employment bargaining," Journal of Macroeconomics, Elsevier, vol. 21(4), pages 765-784.
    14. Kim, Yoonbai & Ying, Yung-Hsiang, 2007. "An empirical assessment of currency devaluation in East Asian countries," Journal of International Money and Finance, Elsevier, vol. 26(2), pages 265-283, March.
    15. Lai, Ching-chong & Chang, Juin-jen & Chang, Wen-ya, 2001. "Currency devaluation in an open-shop union," International Review of Economics & Finance, Elsevier, vol. 10(1), pages 61-74.
    16. Ernst Fehr & Franz Hof, 1994. "Wage bargaining and shock sensitivity of a small open economy," Journal of Economics, Springer, vol. 59(3), pages 259-286, October.

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