Wages, relative Prices and the Choice Between Fixed and Flexible Exchange Rates

How much difference a flexible exchange rate makes to the economic performance of a country depends significantly on wage behaviour. If wages are sufficiently sensitive to exchange rates, flexible rates will exhibit much the same variability of output as a fixed exchange rate regime. Foreign wage behaviour is also of key importance, since high wage flexibility abroad can insulate the domestic country from some foreign disturbances regardless of domestic wage behaviour, while for other economic disturbances it is the relative degree of wage flexibility that determines the desirability of flexible rates. This paper reexamines the choice between fixed and flexible rates taking into account both domestic and foreign wage behaviour. Wage behaviour is important to the choice between exchange rate regimes because it determines to what extent a change in the exchange rate also changes the relative prices of foreigh and domestic goods. It is primarily through changes in relative prices that exchange rates affect domestic output and employment. Traditional treatments of fixed and flexible exchange rates, of which Mundell's Canadian Journal study (1963) is the best known, assumed that any change in the exchange rate resulted in an equal change in relative prices because both wages and domestic prices were assumed constant. When wages are responsive to changes in the general price level, however, domestic prices respond indirectly to changes in exchange rates, with correspondingly less effect on relative prices. In such circumstances, as shown earlier by Sachs (1980), changes in exchange rates lead to relatively small changes in real output and employment.