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Flexible Exchange Rates and Employment Policy

Published online by Cambridge University Press:  07 November 2014

Robert Mundell*
The Johns Hopkins Bologna Center of Advanced International Studies
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The theory of employment that grew out of the Great Depression was not long in influencing government policy-makers and revolutionizing older concepts of fiscal policy. The most important of Keynes's practical lessons, that policies which promote investment and exports and inhibit saving and imports increase employment and output, has now hardened into a dogma and filtered down into almost all the elementary textbooks. The lesson, by and large, was a good one, but the dogma presents the danger that the lesson might be uncritically applied in situations where other government policies render it invalid. This paper is concerned with the most important exception to the rule.

The mercantilist element in Keynesian policies is definitely inapplicable to countries whose central banks do not peg the price of foreign exchange or gold. Tariffs, trade controls, and export subsidies are likely to worsen employment and output in all those situations in which, with a fixed exchange rate, they would improve employment and output. Moreover, if exchange rates are flexible, an increase in investment or government spending, and a reduction in saving or taxation, will have a substantially different effect on employment than that predicted by the traditional foreign trade multiplier. The reason lies in the fact that equilibrium in the balance of payments is automatically maintained by variations in the price of foreign exchange.

Copyright © Canadian Political Science Association 1961

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1 Laursen, Svend and Metzler, Lloyd, “Flexible Exchange Rates and the Theory of Employment,” Review of Economics and Statistics, 11, 1950, 281–99.Google Scholar This important article, and Harberger's justly celebrated Currency Depreciation, Income and the Balance of Trade,” Journal of Political Economy, 02, 1950, 4760 Google Scholar, aroused extensive comment in the literature especially appertaining to the relation between changes in the terms of trade and saving. A useful survey of the literature on the subject is given by Johnson, Harry G., “The Transfer Problem and Exchange Stability,” Journal of Political Economy, 06, 1956.CrossRefGoogle Scholar

2 It is sufficient to refer to remarks by the former Governor of the Bank of Canada, J. E. Coyne, who has argued that less reliance should be placed on fiscal and monetary policy, and more reliance should be placed on commercial policy, to improve employment in Canada. Cf., for example, his remarks delivered at the Annual Meeting of the Canadian Chamber of Commerce in Calgary, October 5, 1960.

3 This model is based on the work of Laursen and Metzler, “Flexible Exchange Rates and the Theory of Employment.”

4 See Appendix, 1.

5 See Appendix, 2.

6 The validity of this conclusion depends on the argument, due to Laursen-Metzler and Harberger, that saving is a positive function of the terms of trade, an argument to which I would subscribe. If the reader prefers to assume that saving is independent of the terms of trade the conclusions of the present paper would not be undermined since its purpose is only to show that commercial policy cannot be relied upon to improve employment, not that more liberal trade policies necessarily improve employment.

7 Among the limitations of the model is the elimination of explicit conditions of equilibrium in the money-capital markets, the implicit assumption being that the central bank, through its open market policy, maintains constant interest rates, except when the latter are explicitly adjusted as parameters. I have examined a few of the dynamic implications of relaxing this assumption in The Monetary Dynamics of International Adjustment Under Fixed and Flexible Exchange Rates,” Quarterly Journal of Economics, 05, 1960 Google Scholar, and more fully in “The International Disequilibrium System,” Kyklos, no. 2, 1961. Much more work remains to be done on the theory of flexible exchange rates.

Another limitation is the treatment of capital movements. Interest rates are only one of the motives for shifting the location of short-term funds, and speculators may serve the function of pegging the exchange rate that the central bank has abandoned if they believe that the central bank will always act to prevent precipitous changes in the exchange rate through stabilization fund activities. Moreover, long-term capital movements may be correlated with the level of domestic activity and hence with the policies which are likely to promote increased employment.

8 Policy implications of theoretical studies need to be qualified before direct application to particular countries. In Canada two facts are especially important. One is multi-regionalism which means that employment may not be directly correlated in different regions under a system of flexible exchange rates. (See the argument in my A Theory of Optimum Currency Areas,” American Economic Review, 09, 1961.Google Scholar) The other factor which must be considered is the “ultra-stabilizing” nature of speculation, described by Rudolf Rhomberg in his doctoral dissertation, “Fluctuating Exchange Rates in Canada: Short-term Capital Movements and Domestic Stability” (Yale, 1959); if speculative capital movements stabilize the exchange rate, the traditional conclusions may hold.

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