Optimal Exchange-Rate Targeting with Large Labor Unions

Vincenzo Cuciniello and Luisa Lambertini

Working Papers from Center for Fiscal Policy, Swiss Federal Institute of Technology Lausanne

Abstract: We study whether monetary policy should target the exchange rate in a two-country model with non-atomistic wage setters, non-traded goods and different degrees of exchange-rate pass through. Commitment to an exchange rate target reduces the labor market distortion. Large labor unions anticipate that higher wages depreciate the exchange rate, which triggers an increase in the interest rate and restrain wage demands. However, reduced exchange rate flexibility worsens the distortion stemming from preset pricing. Targeting the nominal exchange rate will be optimal when the labor market distortion is larger than the preset-pricing one. This result arises with cooperation both under producer and local currency pricing, even though the optimal degree of exchange-rate targeting is higher under local currency pricing. In the Nash equilibrium, the terms-of-trade effect raises optimal wage mark-ups thereby reducing the optimal weight on the exchange rate target. The terms-of-trade effect is stronger as openness and substitutability among Home and Foreign goods increase.

Keywords: Monetary policy; International Finance; Open-Economy Macroeconomics (search for similar items in EconPapers)
JEL-codes: E52 F3 F41 (search for similar items in EconPapers)
Pages: 36 pages
Date: 2009-05
New Economics Papers: this item is included in nep-cba, nep-lab, nep-mon and nep-opm
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Persistent link: https://EconPapers.repec.org/RePEc:cif:wpaper:200901

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