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Real Balances, the Exchange Rate and Indexation: Real Variables in Disinflation

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  • Stanley Fischer
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    The recent appreciation of the dollar is widely believed to have reduced the output costs of the disinflation. But there remains the question of whether those early gains have to be repaid when the exchange rate depreciates.The first question taken up is the effect of real exchange rate appreciation on the sacrifice ratio, or output cost, of disinflation. There is no unambiguous presumption that exchange rate appreciation reduces the sacrifice ratio. The direct favorable effects of cheaper imports on consumer prices, on the prices of imported inputs, and on wage demands, may be outweighed by the unemployment resulting from the reduced demand for exports. In the second part of the paper I examine the affects of wage indexation on the sacrifice ratio. Economists have argued that wage indexation speeds up disinflation; policymakers take the opposite view. The distinction between ex ante and ex post indexing, defined in the paper, explains these different views. Ex ante wage indexation speeds up disinflation. With expost indexation the real wage automatically rises when the inflation rate falls. Even so, ex post indexing may speed up disinflation. But there has to be subsequent downward adjustment of the wage if long-term unemployment is to be prevented.

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    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 1497.

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    Date of creation: Nov 1984
    Publication status: published as Fischer, Stanley. "Real Balances, the Exchange Rate and Indexation: Real Variables in Disinflation," Quarterly Journal of Economics, Vol. 103, No. 1, pp. 27-50, (February 1988).
    Handle: RePEc:nbr:nberwo:1497
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    1. Willem H. Buiter & Marcus Miller, 1991. "Real Exchange Rate Overshooting and the Output Cost of Bringing Down Inflation," NBER Chapters,in: International Volatility and Economic Growth: The First Ten Years of The International Seminar on Macroeconomics, pages 239-277 National Bureau of Economic Research, Inc.
    2. Okun, Arthur M, 1978. "Efficient Disinflationary Policies," American Economic Review, American Economic Association, vol. 68(2), pages 348-352, May.
    3. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-1176, December.
    4. David Backus & John Driffill, 1985. "Rational Expectations and Policy Credibility Following a Change in Regime," Review of Economic Studies, Oxford University Press, vol. 52(2), pages 211-221.
    5. Robert J. Gordon, 1981. "Inflation, Flexible Exchange Rates, and the Natural Rate of Unemployment," NBER Working Papers 0708, National Bureau of Economic Research, Inc.
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