Flexible Exchange Rates and Macroeconomic Policy

In an open economy with a floating exchange rate, the efficacy of fiscal and monetary policy depends fundamentally on the wage-setting process. In the canonical models of Mundell and Fleming, monetary expansion raises output via an exchange rate depreciation, while fiscal expansion has no output effect. These results hold only when 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 interaction of wages and policy in short- and long-run models, under the assumptions of perfect foresight and world capital mobility. After seven years of floating exchange rates, the implications of flexible rates for countercyclical macroeconomic policy remain in doubt. The traditional view, following the pioneering work of Mundell [1963] and Fleming [1962] (henceforth M-F), is that expansionary monetary policy, by inducing depreciation of the 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