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

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.