Wages, the Terms of Trade, and the Exchange Rate Regime

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Discussion Paper

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This paper analyzes a two-commodity short-run macroeconomic model under fixed and flexible exchange rates. Goods are disaggregated into imports and exports. Both are consumed domestically, but only the latter is produced at home. While imports are available in international markets at a fixed price, relative size matters in that the country’s specialized export good faces a less than infinitely elastic foreign demand. The seemingly natural disaggregation used here yields a model that is better suited than traditional models for the analysis of such problems as imported inflation and for flexible exchange rates. Also, the terms of trade is explicit and hence easily distinguished from the exchange rate, and the model can be used to illustrate the relationship between the elasticities, absorption and monetary approaches. A common theme in the contemporary literature on flexible exchange rates is that the exchange rate is determined by financial portfolio decisions; a key assumption implicit in such models is that changes in the exchange rate have no real effects, even in the short run. The present approach imposes more structure on the problem by introducing possible short-run real effects of the exchange rate due to less than infinitely elastic export demand and explicitly specified domestic supply. The stability and comparative static properties of the model are shown to depend crucially on the specification of aggregate supply and the behavior of wages, in addition to relative size, and it is surprising that so little attention has been paid in the literature to this issue.

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