Wage Restraint under Fixed and Flexible Exchange Rates

Peter Rosner, Gerhard Tintner, Andreas Wörgötter, and Gabriele Wörgötter’s 1985 journal article, Lohnzurückhaltung bei fixen und flexiblen Wechselkursen, examines distribution-neutral wage restraint in a small open economy. Its central distinction is between eventual employment gains and the contraction that may precede them. Exchange-rate flexibility changes the adjustment path, but not the model’s equilibrium real effects. Against the background of persistent unemployment after the oil crises, the authors make demand—not wage reduction alone—the condition of employment recovery:

Von Keynes wissen wir, daß Nominallohnkürzungen nur dann zu einer Erhöhung der Beschäftigung führen werden, wenn sie von einer steigenden Güternachfrage begleitet sind.

English translation: We know from Keynes that nominal wage cuts will lead to an increase in employment only if they are accompanied by rising demand for goods.

The article develops a modified Dornbusch model, analyzes wage restraint separately under fixed and flexible exchange rates, and then compares policy responses to higher foreign real interest rates. The small-country assumption excludes feedback from domestic restraint to foreign economies. Goods demand depends on international competitiveness, the real interest rate, and an exogenous demand variable encompassing fiscal policy and foreign demand. Rational expectations and perfectly substitutable domestic and foreign securities connect interest rates to expected exchange-rate movements.

Crucially, wage restraint means slower wage and price increases together, rather than a redistribution from wages to profits. Domestic prices equal nominal wages in the model, keeping the wage measured in domestic goods constant. The consumption real wage nevertheless falls when foreign goods become relatively more expensive through real depreciation. Employment gains therefore depend on sufficiently responsive exports and import substitution. Spare capacity permits demand-led production increases; output and employment move proportionally. The analysis covers an adjustment interval over which price and quantity effects unfold but capital accumulation and other stock changes can be disregarded.

Under fixed exchange rates, nominal wages and prices cannot jump because contracts delay adjustment. A restraint policy immediately lowers expected inflation and raises the real interest rate before competitiveness improves. Domestic demand, output, and employment consequently fall; reserve outflows accommodate reduced money demand while maintaining nominal interest parity. Only as wages and prices decline does real depreciation generate the additional external demand needed for recovery. The new equilibrium has higher output, but reaching it entails an initial increase in unemployment:

In einer kleinen offenen Volkswirtschaft mit kontraktbedingten Lohn- und Preisrigiditäten ist daher bei fixen Wechselkursen auch mit Hilfe einer verteilungsneutralen Einkommenspolitik eine „schmerzfreie“ Deflation nicht möglich.

English translation: In a small open economy with contract-induced wage and price rigidities, therefore, even distribution-neutral incomes policy cannot make “painless” deflation possible under fixed exchange rates.

This timing argument grounds the authors’ disagreement with Holtfrerich’s treatment of wage restraint and exchange-rate adjustment as comparable instruments. A currency depreciation can change relative prices immediately; restraint imposed through renewed contracts cannot. An instantaneous wage-price cut would likewise have different transitional effects from an ongoing restraint policy. The latter can produce lasting real gains, but its disinflationary interest-rate effect initially works against them. The discussion of foreign competitiveness shocks also rejects the idea that fixed exchange rates necessarily eliminate a pronounced Phillips-curve relationship: wage adjustment remains one transmission channel alongside trade and interest-rate responses.

Under flexible exchange rates, the currency can jump onto the stable path of a saddle-point equilibrium while wages and prices adjust gradually. Restraint may initially produce either depreciation or appreciation, depending on model parameters. Appreciation unambiguously lowers initial output because competitiveness deteriorates while the real interest rate rises. With initial depreciation, the output response need not be negative: improved competitiveness may offset the interest-rate effect. The authors thus distinguish parameter-dependent transitional outcomes from a shared equilibrium result:

Dabei zeigt sich, daß die Beschäftigungswirkung einer Politik der Lohnzurückhaltung bei flexiblen Wechselkursen gleich groß ist, wie bei fixen Wechselkursen.

English translation: It emerges that the employment effect of a policy of wage restraint under flexible exchange rates is just as large as under fixed exchange rates.

This finding contradicts the claim that appreciation under floating rates necessarily cancels restraint’s employment benefits. It does not establish that floating rates guarantee an easier transition. Exchange-rate overshooting and unemployment overshooting remain possible, and the direction of the initial currency movement cannot be inferred without further parameter information.

The concluding policy comparison asks how to counter an increase in foreign real interest rates. Under fixed rates, fiscal expansion can offset the demand loss both immediately and in equilibrium, within a model excluding wealth effects, foreign interest-payment effects, and political constraints. Devaluation alone removes unemployment overshooting but not the equilibrium employment loss. Wage restraint can restore equilibrium employment while worsening the initial contraction. Appropriately combining devaluation and restraint can reproduce fiscal stabilization.

Under flexible rates, fiscal expansion restores equilibrium output but generates transitional overshooting. Monetary adjustment can remove overshooting without reversing the equilibrium real loss; its required direction depends on detailed parameter knowledge, making the prescription practically doubtful. Combining monetary and incomes policies can theoretically stabilize both horizons, again subject to that informational limitation. The authors’ final judgment is deliberately comparative:

Zusammenfassend kann man sagen, daß das Wechselkurssystem für den Erfolg einer Strategie der Lohnzurückhaltung nur eine marginale Rolle spielt.

English translation: In summary, one can say that the exchange-rate system plays only a marginal role in the success of a wage-restraint strategy.

The article’s contribution is to separate competitiveness gains from the demand costs of achieving them. Wage restraint can improve equilibrium employment under either regime, yet frequently intensifies an existing recession along the way. Its policy relevance lies in showing why eventual recovery cannot establish restraint as an adequate short-run stabilization instrument, and why demand support or coordinated policy must be evaluated alongside wage adjustment.