732€¦ · real-wage rigidity, ln Section II the short-run M-F model is extended to compare the implications of nominal-wage and real-wage rigidity. The simple comparative statics

WAGES, FLEXIBLE EXCHANGE RATES, ANDMACROECONOMIC POLICY*

JEFFREY SACHS

In an open economy with a floaLing exchange rate, the efficacy of fiscal andmonetary policy depends fundamentally on the wage-setting pnxiess. In the canonicalmodels of Mundell and Fleming, monetary expansion raises output via an exchangerate depreciation, while fiscal expansion has no output effect. These results hold onlywhen real wages can be altered by exchange rate movements; if the real wage is fixed,the Mundell-Fleming ranking of policy is reversed. This paper explores the interactionof wages and policy in short- and long-run models, under the assumptions of perfectforesight and world capital mobility.

After seven years of floating exchange rates, the implications ofHexible rates for countercyclical macroeconomic policy remain indouht. The traditional view, following the pioneering work of Mundell1196;?) and Fleming [1962] (henceforth M-F), is that expansionarymonetary policy, hy inducing depreciation ofthe real exchange rate,is effective in raising output in a small, underemployed economy.Fiscal policy, on the other hand, is seen as less effective. In the stan-dard analysis, a rise in government spending leads to appreciation andcrowding-out of net exports.

An alternative view of flexihle rates, set forth in the full-em-ployment models of glohal monetarism, maintains that a moneysupply expansion can change only the exchange rate and price level,but not output and employment. While an increase in money causesdepreciation ofthe nominal exchange rate, the domestic price levelrises to offset the competitive gain envisaged in the M-F model. Thealternative view has had less to say on the effects of fiscal policy andon the general question of prolonged unemployment.

Both views of monetary policy have adherents, and there is evi-dence, in different countries and at different times, to support each.Their appropriateness, I shall argue here, depends crucially on thenature of the wage-determination process. The M-F model (in anextended form) requires that nominal exchange-rate changes alterthe real wage. Implicit is an underlying view, going hack to Keynes,

* 1 would like to thank Michael Bruno, Rudiger Dornbusch, Dale Henderson, andJanet Yellen for very helpful discussions, and Susanna French for editorial aasis-lance.

1. The original models ignore wages altogether, letting prices be rigid. Since theeconometric evidence overwhelmingly suggests that prices are markups over wages,we adopt the interpretation that wages are rigid and that prices adjust to wages. Prices;ire later described according to a variable markup, in line with marginal-cost pricing.None of the qualitative conclusions of the paper are changed if we adopt a fixed-markuppricing rule.

o 1980 by the President and Fellows of Harvard College. Published by John Wiley & Sons, inc.The Quarterly Journal of Economics, June 1980 003:5-5533/80/0094-0731 $01.70

732 QUARTERLY JOURNAL OF ECONOMICS

that in the short run, nominal wage changes proceed somewhat in-dependently of price level changes. A contrasting hypothesis is thatreal-wage developments are little influenced hy nominal values. Inthis case the M-F conclusions regarding monetary and fiscal policyare reversed.

The suggestion that real-wage rigidity vitiates monetary policyis familiar from closed-economy models. However, the mechanismthrough which wage determination and output are connected is quitedifferent in the closed- and open-economy cases. In the open economythe consumer price level is a function of domestic and foreign prices.The general price level can change even when domestic prices arefixed. Monetary policy has direct links to prices through exchange-ratechanges. Also, there is no one-to-one relationship between real wages(nominal wages deflated hy the CPI) and aggregate supply, as thereis in a closed-economy model. The output supply of domestic firmsis determined by the ratio of wages to domestic prices. Since the ratioof domestic to foreign prices can be altered, different levels of aggre-gate supply are consistent with the same real wage. Finally, a real wagedecline increases output through different channels in closed- andopen-economy models. In the closed economy a drop in real wagestends to reduce the real interest rate, thus boosting aggregate demand.In the open economy, which faces a given world real interest rate, thepath is from real wages to international price competitiveness.

The analysis is divided into three parts. In Section I some dataare presented to support the relevance of models with short-runreal-wage rigidity, ln Section II the short-run M-F model is extendedto compare the implications of nominal-wage and real-wage rigidity.The simple comparative statics results repeat the conclusions in Casas[1975], Argy and Salop [1977], and Sachs [1978]. New results are ob-tained by allowing for short lags in wage indexation and changes inreal-wage levels over time. The time horizon of the short-run modelis extended in Section III, where we allow for wealth effects due tocurrent account imbalances.

I. WAGE DETERMINATION IN OECD ECONOMIES

Two contrasting views of wage determination have dominatedmacroeconomic discussions in recent years, labeled by Perry [1975]as wage-Inertia (or wage-wage) versus wage-price models. In the first,wages follow an auto-regressive scheme; nominal-wage change in thecurrent period is determined by the past pattern of nominal-wagechange and by the level of unemployment. In the wage-price model

WAGES. EXCHANGE RATES, AND POLICY 733

nominal wages adjust to current or expected price changes in orderto keep real wages moving close to targets, which may in turn be in-fluenced hy the unemployment rate. In the wage-wage model realwages can he altered by anticipated monetary policy, while in thewage-price model they cannot.

The wage-wage hypothesis goes back to Keynes's observationthat workers' concern for relative wages may lead to sluggish nomi-nal-wage change in decentralized labor markets. Posner recently of-fered a dynamic version of this view:

The inflationary process is mit, therelore, seen as a question of money waês pursuingprofits, or pursuing (with a lag) the course of prices, or pursuing an expected rate ofincrease in real incomes. It is a leapfrogging process in which each union negotiatingofficer strives lo do at least as well and preferably just a wee bit better than the othermembers of his club [Posner, 1978, p. U).

The hypothesis is formalized in a model of overlapping long-termcontracts by Taylor [1978].

A number of other studies have concluded that, on the contrary,wage bargains are designed to preserve the trend growth of real wages(see Solow [1979]). Implicit-contract theory predicts that a stable realwage for the duration of a contract may be the market equilibriumofthe supply and demand for labor under uncertainty. From anotherpoint of view, Hicks predicts that stable real-wage growth will resultfrom labor-supply behavior and the activity of trade unions. He de-scribes why workers will resist real wage declines:

The wage-earner's test for fair wages is not simply a matter of comparison with otherpeoples' earnings; it is also a matter of comparison with his own experience, his ownexperience in the past. It is this which makes him reai.st a reduction in hia money wage,but it also makes him resist a reduction in the purchasing power of his wages, and even;i reduction in the gn)wth of that purchasing power to which he has become accustomed(Hicks, 1975. p. 5].

With sufficient market power, Hicks continues, the worker's tradeunion will be successful in protecting real wage growth in the shortrun. Solow [1979] also describes a formal model of trade-union wagebehavior for which real-wage stickiness is a Hkely outcome.

Descriptive studies of labor-market institutions as well aseconometric analysis suggest that the real-wage model is for manycountries more relevant for short-run microeconomic models (thoughthe United States is a case where significant wage inertia is apparent).Formal indexation of wages to changes in the consumer price indexis common throughout the world.^ The scala mobile of Italy guar-

2. For a survey of indexation arrangements in industrial countries, see Braun11976].


TABLE I

ANNUAL PERCENTAGE CHANGE IN REAL HOURLY COMPENSATION: 1960-1977

1960-731973-751973-761973-77

UnitedStates

1.860.401.141.40

UnitedKingdom

3.416.364.682.15

France

5.125.565.564.87

Germany

6.667.155.215.19

Italy

7.508.105.825.56

Canada

2.863.804.153.59

Japan

8.334.762.992.60

Source. Real hourly earnings are calculated as average hourly compensation in manufacturing defluted hythe conaumer price index. The *age data are from the 11. S. Department iifliabor. Bureau of LBliiirSt«listic.ii,Ofr[L*of Productivity and Technology, Oulpul. per Hiiur. Hourly Compensatiiin. and Unit Labor Citsts in Manufacturing,Elenen Countries. 1950-1977 {May i, 197SI; the price data are from the/ntefflationoJFinancio/SfaiisticB nftheIMF.

antees close to 100 percent indexation of wages for a large segmentof the work force {see Lubitz [1977] and Faustini [1976]). Incomespolicies in Britain have actively encouraged the use of contracts thatlink wages to the consumer price index (see Miller [1976J, p. 513).Similarly, it has been shown that the Australian Conciliation andArbitration Commission sets the National ]Vlinimum Award Wageto protect (or indeed to accelerate) real-wage growth (see Pitchford[1977]). Further examples abound.

These mechanisms for preserving real-wage growth have beentested in recent years. Table I illustrates the constancy of real wagegrowth in the face of the worldwide "great recession" of the mid-197O's. In Bruno and Sachs [1979b] it is argued that the 1973 oil-pricehike and the boom in primary commodities required a substantialdeceleration of real-wage change for output growth to be maintained.Except in the United States and Japan, no deceleration in real-wagechange is evident until two years into the recession; in 1976 real wagesdeclined relative to trend. The very high inflation rates in 1973 and1974 did little to moderate real wages.

Elsewhere [Bruno and Sachs, 1979b] I describe a test to dis-criminate between wage-wage and wage-price behavior in sevenOECD economies. Regressions are presented describing nominal-wagechange as a linear function of past wage changes, expected pricechanges, and lagged unemployment. In France, Germany, Italy,Japan, and the United Kingdom, the coefficient on lagged wages isnot significantly different from zero when expected inflation is in-cluded in the regression; only in Canada and the United States didlagged wage change affect current wage change. Only in the latter twocountries is there evidence that changes in expected inflation alter

WAGES, EXCHANGE RATES, AND POLICY 735

the real wage, as is required in the M-F model.'' As is suggested byTahle I, real wages exhibited a statistically significant lagged responseto unemployment in all countries except the United States andCanada.

II. T H E SHORT-RUN MODEL

In this section it is shown that real-wage rigidity alters theranking of monetary fiscal policy in the short-run M-F model, as firstdescribed in Casas [1975]. The comparative statics results of thereal-wage model are extended to include two dynamic elements: lagsin wage indexation: and declines in real wages in response to sustainedunemployment.

The following notation is used:

E

GHKLMP

stock of short-termbonds denominatedin foreign currencyunitsexchange rate, in unitsof domestic currencyper unit of foreigncurrencygovernment spendinghousehold wealthcapital stocklabor inputmoney supplyoutput price

Pc

Q

R

S

TW

w.Y

nX

consumer price index

output

interest rate

household savings

trade balancenominal wagereal wage (VV/Pc)national incometerms of tradeweight of domestic goods inCPI

Superscript e indicates expectation; asterisk indicates foreign;lower-case letters denote logarithms of upper-case variables. For allX, X, denotes the partial derivative of X with respect to its itharguments. The time rate of change of X, dX/dt, is denoted by X, thesteady-state value of X by X.

We turn first to the aggregate supply side. Technology is char-acterized by the neoclassical production function F{K,L) with fixed

'.\. Using the notation listed below, the estimated equation is w, = oo + «i (logmanhours) + a2«'(-i + (1 - «y)/ir, +tV3(tinie) + (,. IftV2= 1, we have a pure wage-wageprocess. If tv = 0. we have a wage-price process. The regression can be rearranged toyield li',. = (»o + ai (log manhiiurs) - a-z^p't^ - Wt-\) + (/>r - pc,) + «a (time) + u- If((2 > 0, an acceleration of expected inflation above last period's nominal-wage changewill reduce the real wage. For details see Bruno and Sachs [1979bl.


capital stock. Firms operate under conditions of perfect competition,and employ labor according to W/P = F2- Simple duality theorypermits us to write output as Q = Q{WlP,K) anAQi <0andQ2>0-Log-linearizing, and ignoring the constant capital stock, we have"*

(1) q = —a{w - p) output supply.

With domestic consumption of home and foreign goods, a trueprice index may be approximated by Pc = P^{P*Ey^~''\ where X isthe share of domestic goods in domestic consumption (the index isexact for a Cobb-Douglas utility function). Thus, Pc = \p +(1 — X)(p* + e). Equation (1) may be rewritten as

(1') q = -awc + ^TT,

where TT = p — p* — e,Wc = w — pc, and / = (1 — \)cx. For any givenreal wage, an increase in the terms of trade TT reduces the product wage{w — p), thus raising aggregate supply.

We adopt a simple form for the two wage hypotheses:

(2) w = Wl) + Opf. wage equation.

For 6 = 0, nominal wages are fixed at wo. For 6 = 1, real wages are fixedat WQ.

A semi-reduced-form segregate demand schedule is specified:^

(3) q = 7]D* + y-2g + 7.-)7' aggregate demand

and

(4) T = -6iq + OzQ* - O'^TT trade balance.

In (3) aggregate demand is a positive function of net claims on for-eigners, D*, through a wealth effect,** a positive function of the fiscal

4. For a CES production technology, a = arr/d — a), where a is the elasticity ofsubstitution and a is the output elasticity with respect to labor.

5. Consider the following brief derivati<m (see Dombusch |1976al, for a similarmodel). With 3 Metzler savings function, savings is proportional to the gap betweendesired wealth H'^ and actual wealth H. We define net household wealth as the net bondclaims of domestic residents on the rest of the world, in domestic currency units ED*IP(high-powered money is not included in wealth, for reasons described in note 6). [nturn, H'' is a fixed multiple of disposable labor income. For lahor share in output a,we have S = uiW - H), H'' = A(aQ - G) (with a balanced budget and ignoring do-mestic bonds, taxes equal government spending G). From the national-income ac-counting identity, C + S + Tax = V, where Y is national income. In turn, V = Q +R*{ED*/P): Y is equal to domestic output plus net income flows from abroad. Finally.Q = C+G + T. Putting all the pieces together, we find that Q = [lu + R*){ED*IP)+ u\G + T\lu\a. To get (3), we (log) linearize around the initial equilibrium D* = 0:E/P = 1. Note that when T = -R*(ED*/P) (i.e., the current account is balanced), Qis an increasing function of D*. This will be important in Section III.

6. High-powered money is a very small traction of household wealth, and can thusbe ignored. By leaving M/P out of H. we simplify tbe analysis by ensuring superneu-trality in the real-wage model. The real side of the model may he solved independentlyof the nominal exchange rate. For a discussion of this assumption see Blanchard[1979].

WAGES, EXCHANGE RATES. AND POLICY 737

variable G, and an increasing function of the net trade balance T. In(4) we take the simplified view that export and import demand arefunctions only of output and the terms of trade. Assuming thatMarshall-Lerner conditions are satisfied, we have that 0:^ > 0.

The model is closed by specifying the asset-market structure andthe accumulation of domestic wealth,

(5) m — p = tpq — bR + hD* money demand.

Money demand is an increasing function of domestic output and bondwealth and a decreasing function of the domestic short-term interestrate.'' Given perfect capital mobility, the rate of expected depreciationmust equal the interest-rate differential,

(6) {eV = R ~ R* covered interest arbitrage.

Finally, domestic holdings of foreign debt change according tothe current-account balance, which is the sum of the trade balanceand the debt-service account,

(7) {e/P)D* = T + R*(eD*/P) current-account balance.

The model is solved in three steps. First, the simplest M-F modelis analyzed: a short-run perspective is adopted, and changes in D*according to (7) are ignored. Next, two dynamic elements are addedto the real-wage version of the model: lags in wage indexation andlonger run responses of real wages to unemployment. Finally, in thenext section equation (7) is reintroduced and a more accurate, long-run model is examined.

Solving equations (r)-(5) and imposing the rational expectationthat (ey = e = 0, we find that

(8) dq =

where A = 7303(1 + (1 - 6)a(t>] + Oa{l - X){1 -I- 6/173) > 0. Fiscal policyis effective for a fixed real wage (0 = I), and ineffective when thenominal wage is rigid (0 = 0). The reverse is true for monetary policy.The home economy is insulated from changes in foreign output q*only when the nominal wage is rigid; otherwise the shock is trans-mitted positively. Finally, attempts to raise the real wage by increasingtt'o reduce income.

Consider these results in terms of aggregate supply (1'). Monetarypolicy w{)rks in the M-F model by reducing real wages; fiscal policy

7. Money demand is written as a function of ED*/P and then linearized aboutI he point D* = 0. As is welt-known, if the initial claims on foreigners are positive, orif the money stock is deflated by P.. rather than P. the strong M-F result about theinefficacy of fiscal policy disappears. I have chosen the specification in (5) in order tobetter contrast the cases of nominal and real wages.


is ineffective because, although it improves the terms of trade, thefiscal expansion raises real wages. Analytically,

(9) dwc = a^dg + 02(^9* - a^dm,

where oj = (1 - S)72(l + «0)(1 " ^)A"^ > 0; as = d - 0)^-^0(1 + a^)(l - X)A-i > 0; an = (1 - ^) W 3 + «(1 " X)(l + Oî)]^''> 0. When the real wage is fixed, fiscal policy raises the terms of tradewhile monetary policy has no effect on Wc or TT.

The effects of m, g, and g * on wages are understood by turningto the asset markets. In the short run an increase in m causes a de-preciation ofthe exchange rate, a rise in import prices, and a rise inPc. If nominal wages are sticky, the real wage declines. Contrariwise,a fiscal expansion induces an appreciation and reduces pt.^ With0 = 0, We rises.

The assumption of a fixed short-run real-wage can he made morerealistic in two important ways. First, even when labor-market in-stitutions are geared to preserve a given short-run real wage,«'( mightvary because of lags in indexation of wages to price movements (seeModigliani [1978] for such a view). Second, the real wage will even-tually respond to unemployment. We now turn to these modifica-tions.

8. The equation for dir ia

+ (1 - fl)(V0lA-') - dm(l - e)[a(l +

9. An increase in the money supply exerts downward pressure on interest ratesAt a given world interest rate, an incipient capital outflow is induced, leading to cur-rency depreciation. The fiscal expansion puts upward pressure on interest rates, andcauses currency appreciation. The equations for dpc and de are

+ 63dm -

where

61 = 72(1 + a<t>W - A)A-' > 0;

b2 = 73^2(1 + tt0)(l - AjA-' > 0;

64 = ((>73^3« - (I - X)(l + fli73)"lA-i % 0;

de = —v\dg - c^dq* + Cidm +

where

Cl = 72tl + (1 - O\)a<l)]A-^ > 0;

C2 = 73^2(1 + (I - «X)a,/.]A-i > 0;

-^ > 0;

0.


la. Cose of 1 +

u

lb- Cose ot 1

FIGURE IWage and Exchange Rate Dynamics

Indexed contracts typically provide for a lag of at least one-quarter in wage adjustment following a CPI increase. As an example,in Stage 3 of the British 1972-1974 incomes policy, wage indexationwas subject to the condition that nominal wages were not to he ad-justed until a threshold price increase had been passed. The effect ofthe oil price increase in 1973-1974 was to reduce British real wagesfor two quarters, after which they more than recovered. With informalwage indexation a union may have to wait until the next round ofcollective bargaining to restore real wages.

These lags suggest a simple dynamic rendering of the real-wagemodel. Instead of (2) we write

(2')= W() +

w = — w),


where u;' is the target nominal wage. Actual wages adjust to close thegap between w and «?'.

A number of interesting conclusions emerge from the solutionof (r) , (20, and (3)-(6). Because of the lags in wage adjustment,monetary policy will work in the short run, even though the equilib-rium real wage is fixed. On impact, the money expansion increasesq; later, domestic price increases cause q to return to the initial level.Fiscal multipliers, on the other hand, are smaller in the short run thanin the steady state. Indeed: the impact multipliers of a fiscal expansionmay be negative. Finally, exchange rates may overshtwt or undershootlong-run values after a policy change, for reasons described in Dorn-busch [1976bl.

Once again, the multiplier results are best understood in termsof aggregate supply. A money expansion causes a spot depreciation,reducing Wc on impact and increasing aggregate supply at the giventerms of trade. Since aggregate supply exceeds aggregate demand, theterms of trade worsen, competitiveness improves, and domestic de-mand increases. Aggregate supply contracts as Wc rises toward WQ. Thefiscal expansion, on the other hand, induces an appreciation and raisesWe- As w falls in response to the reduced pc, aggregate supply expandsto the level shown in (8).

The dynamic model can be described formally by a two-variablelinear differential equation system:

i:where

Oil ~ —4^^T l^sT:! "f" (1 — X)tv(l + "VS"! ] * ' '>

ai2 — —Qn > 0>

02] = 6""'A"^[rt(l + 73^.'! — 073^3)] % 0;

and

Aj = CY{1 + 73^1) + ^373.

.021 022! I e -

Because the determinant 012 22 ~ 021012 < 0, the characteristicroots are real and of opposite sign, indicating saddlepoint stability.The phase pltuie representation is sbown in Figure I, for the two cases1 -I- 7;,î - 073/93 > 0 and 1 + 73^1 - 073^3 < 0. The dashed line in-dicates the single stable arm; the exchange rate always jumps to keepthe economy along the stable trajectory.


= 0

"t'O

2o Moneiory expansion- cose of ' *

2b. Fiscal exponsioni case of

FIGURE IIMonetary and Fiscal Expansion

Consider a monetary and fiscal expansion in the case 1 + 73^1- 073^3 > 0. After a money supply increase (Figure Ila), the exchangerate depreciates to ef=o- The price level rises, and Wc falls. Subse-quently, wages and prices rise to the new equilibrium, in equipro-portion to the money supply increase. The fiscal expansion (Figurelib) induces a spot appreciation and reduces prices. Since u;,. rises,the impact multiplier is less than the multiplier calculated earlier.

In the case of 1 -t- 73^1 - 073 /3 < 0, the impact fiscal multiplieris negative (Figure III). The spot appreciation of the exchange rateis less than the long-run appreciation. Since e < 0 at £0, we must haveR < R*. Given money-market equilibrium, this is possible only if atto, q falls below its initial level.

Finally, it is easy to show that a monetary expansion will causethe exchange rat« to overshoot if and only if I + 73^1 - 073( 3 > 0 (thegraphical proof is immediate).


e

t=0

Ls

I I

Case of

FIGURE HIFiscal Expansion

Our analysis of the simple M-F model is completed by treatingthe case of short-run real-wage rigidity with longer-run real-wageflexibility. In Bruno and Sachs [1979a] an economy is described inwhich real wages respond slowly to the gap between the labor inputand long-run desired labor supply. After an expansionary shock ing orq*, output rises according to (8). Labor input also rises, by theamount dq/a, where a is the output elasticity of labor. If desired laborsupply is not infinitely elastic, there will be excess demand ior la-bor at the initial Wc, and real wages will begin to rise. We saw earlierthat increases in WQ reduce output, so the induced rise in real wagesreduces the multipliers of g and q* on q. Some of the expansionaryeffect is dissipated by an increase in w^ and 7r, and a fall in worldcompetitiveness.^**

III. T H E LONG-RUN MODEL

As is well-known, the short-run M-F model is seriously flawedby its failure to treat the long-term wealth effects of current-account

10. Suppose that the long-run wage elaaticity of labor supply is p, and that thereal wages adjust slowly to close the gap between labor mput and desired supply: u>,= u ( / - / s ) = tx{l - pwr). Since I = q/a {up to a constant term), equilibrium real wagesare given by Wc = q/pa. If we add this condition to the model solved earlier (in tjie caseof e = 1), the output equation is d</ = d^'l«72(l - X)A2'] +d(/*l7a"2"(l - AjAj ],where Aa = y-idsd + txjpa) + (1 - X)(l + O^z) > A > 0. The multipliers on i! and q*have been reduced.

WAGES. EXCHANGE RATES, AND POLICY 743

imhalance.i' Here we add the wealth effects to the model of SectionI, to see whether the distinction between nominal-wage and real-wagerigidity remains important in the long run. The answer is that it does,though in an unexpected way.

As shown in Rodriguez [1979] and Sachs [1979], the conclusionsof the M-F model must be altered if the wealth Hows due to current-account imbalances are taken into account. With a fixed nomimalwage the long-run multipliers of monetary and fiscal policy are bothlikely to be positive, unlike the zero multiplier on g in the model ofSectitin 1. With real-wage rigidity, the money multiplier is again zero,given the nominal-real dichotomy ofthe long-run model. The long-runfiscal multiplier, however, is negative.

Under both wage assumptions, the fiscal expansion raises outputand leads to a current-account deficit on impact. D* falls accordingto (9). The decline in wealth causes aggregate demand to fall. If realwages are rigid, the initial output level is reached and the trade ac-count is again in balance. But the decline in D* has now moved thedebt-service account into deficit, and the overall current accountremains in deficit. Output must decline still further in order to reduceimports, thqs balancing the debt-service account deficit with atrade-account surplus. With fixed nominal wages, the decline in D*is eventually accompanied by a depreciation of the currency. Realwages fall, aggregate supply expands, and the economy's internationalcompetitiveness improves. The current account is balanced at a higherlevel of output hecause ofthe improvement in competitiveness.

The long-run multipliers are found by solving equations (1'),i2)-(6), and requiring that D* = 0 in (7). Equation (7) is linearizedaround E/p = 1, A* = T = 0, so that D=T+ R*D*:

(10) dq = lA3~'(7i - 73/e*)(l - e)daa]dm+ [5l93(l - fi)oc - R*aa - \)0]y2Ar^dg+ IA;r^^2(Ti - ysR*)»m - \)]dq*,

where

A;, = {1 - 010193(71 - 73/2*)tv + dM]

+ (7! - yaR*)[O;i + H.aen - X)] - aO{l - \)R\

7i - 73/?* is assumed to be positive.12 When £/ = 0, A3 is necessarily

11. Recent papers that discuss long-run wealth effects of the current accountinclude Dnrnhusch and Fischer |197H], Rodriguez [1979|. and Sachs |1979l. None ofthese papers compares adjustment under alternative wage assumptions.

12 Since (/= 7iO* + 7-2^-1-73r. and T =-/?»D*. (7, - 7:,fl') >() is the con-dition thai an increase in Inne-run D* raise aggregate demand. The condition emergesnaturally from a structural derivation of equation (3). See note 5.


positive. For 0 = 1, stability requires A^ to be positive, and this is as-sumed.i-' Thus, for 8 = 0, dq/dm > 0, and dq/dg > 0. For f' = 1, dq/dm= 0, and dq/dg < 0.

These results are sensitive to the specification ofthe trade bal-ance. We have assumed that net exports depend only on output andnot on the distribution of income between the private and publicsector.^'' If a balanced-budget fiscal expansion shifts demand fromforeign to home goods, the fiscal policy can increase q in the long runeven with rigid real wages. Thus, we must distinguish analyticallybetween the expenditure-increasing and the expenditure-switchingeffects of government spending. When fiscal policy is effective in thelong run, the short-run multiplier will tend to be greater than thelong-run multiplier.

The impact effect of fiscal poliey is positive in both the nomi-nai-wage and real-wage models. The dynamic equations for thenominal-wage model are

I e I _ [fell 6i2][ (^ ~ D*\ [621 fc22][/?* -^

where

bj., = i)^Âj'[A46 + 7i(tv0 + 1)] > 0;

- 0:iA4) > 0;

f ds)] e 0,

where A4 = tv + cyyÔ^ + y^^fh > 0.In Figure IV a phase plane representation of a fiscal expansion

is shown for the case 6..2 < 0. Sinee 6ii/?22 - ''21^12 < 0. we again havesaddlepoint stability. With a fiscal expansion the D = 0 locus shiftsup, and the e = 0 locus shifts down. The exchange rate depreciatesalong the adjustment path, so /?,=« > RUo- By the money marketequation, yt=Q must be greater than the pre-expansion level. ' Notethat the exchange-rate depreciation coincides with a current-account

13. Using (1') and {2)-(7) under the condition « = 1, we find that dt)*/dD* =-A3[a(l - X) + «(1 - XlTa i + ^37:1)"'. Since this expression must be negative Torstability. A3 must be positive. . .

14. Equation (7) suggests that the private and public sector marginal propensitiesto import are equal, or that imports are in large part intermediate and capital goods,tied less to income than to output.

15. Substituting (1) into (5), m-iv = (<}> + l/a)q ~ bRW*. A rise in R at constantD* requires a rise in y for money-market balance.

WAGES, EXCHANGE RATES, AND POLICY

6"-o

745

FIGURE iVFiscal Expansion in the Long-Run Model with Nominal-Wage Rigidity (622 < 0)

deficit, as found in other models (e.g., Dornbusch and Fischer [1978]).In the case, b-i-z > 0 (not shown), the same conclusions hold.

In the real-wage case, the impact effect of fiscal policy is givenby (8), if we ignore lags in short-run indexation. The comparativestatics result of the short-run model coincides with the impact effectin the long-run model. As D* falls, q falls below this initial level. Bysolving the full dynamic system, it may be shown that the exchangerate again depreciates with a current-account deficit and appreciateswith a surplus.

V. CONCLUSIONS

In discussing the merits of alternative macroeconomic policiestor open economies, too little attention has been paid to labor-marketanalysis. I have argued that the wage-wage and wage-price models leadto fundamentally different conclusions regarding the efficacy of fiscaland monetary policy. At issue is whether real exchange rates and realwages can be changed by movements in nominal exchange rates. Ifso, the Mundeil-FIeming conclusions are upheld; if not, the oppositeconclusions obtain.

The distinction between real-wage and nominal-wage adjustmentpatterns is not merely a feature of small-country models. In thestandard short-run, two-country model, a fiscal expansion in onecountry raises income in both. Not so with fixed real wages in bothcountries. The fiscal expansion is beggar-my-neighbor, raising income


at home and decreasing income abroad (see Bruno and Sachs[1979bl).

Unfortunately, the empirical evidence of Section I suggests thatthe task of policy is complicated by the presence of different wage-adjustment patterns in different countries. The two views of wage-determination must be subjected to more rigorous empirical analysis,so that informed policy choices may be made.

HARVARD UNIVERSITY AND NATIONAL BUREAU OF ECONOMIC RESEARCH

REFERENCES

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Bruno Michael, and Jeffrey Sachs, "Macro-Econoniic Adjustment with Import PricrShocks: Real and Monetary Aspects," Discussion Paper No. 793, Jerusalem: FalkInstitute, 1979a. , , ^^ „ . .., and . "Supply Versus Demand Approaches to the Problem of btagrlation.Discussion Paper No. 796, Jerusalem: Falk Institute, 1979b.

Casas, F. R., "Efficient Macroeconomic Stabilization Policies Under Floating ExchangeRates," International Ecunomic Review. XVI (Oct. 1975), 682-98.

Dornbuach, Rudiger, "Capital Mobility, Flexible Exchange Rates and MacroecnnomicEquilibrium," in Recent Issues in. International Monetary Economics. E. Classenand P. Salin. eds. (Amsterdam: North-Holland, 1976a).. "ExpecUtions and Exchange Rate Dynamics," Journal of Political Economy.LXXXI (Dec. 1976b), 1161-76. „ ^,. ^ ,and Stanley Fischer, "Exchange Rates and the Current Account, unpublished

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WAGES, EXCHANGE RATES, AND POLICY 747

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Rodriguez, Carlos Alfredo, "Short- and Long-Run Effects of Monetary and FiscalPolicies under Flexible Exchange Rates and Capital Mobility," American Eco-nomic Review. LXIX (March 1979), 176-82.

Sachs. .Jeffrey. "Wage Indexation. Fiexible Exchange Rates and MacroeconomicPolicy," paper presented at the American Economic Association Meetings, Chi-cago. September 1978., "Short- and Long-Run Effects of Monetary and Fiscal Policies under FlexibleExchange Rates and Perfect Capital Mobility: Comment," unpublished draft.May 1979.

Solow. Robert M., "Alternative Approaches to Macroeconomic Theory: A Partial View,"W. A. Mackintosh Lecture, Queen's University, Kingston, Ontario, March1979.

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732€¦ · real-wage rigidity, ln Section II the short-run M-F model is extended to compare the implications of nominal-wage and real-wage rigidity. The simple comparative statics