Flexible Exchange Rates and Employment Policy

Introduction to the 1961 study:

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 govermnent 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. These simple truths have already been anticipated in the theoretical literature by the argument that, under flexible exchange rates, depression in one country may transmit inflation instead of depression to other countries. Yet there remains a serious gap in the literature since the explicit implications of the argument for employment policy have not been explored, nor are they sufficiently appreciated by government authorities. Consequently I shall examine the effects of fiscal policy, monetary policy, and commercial policy on the level of employment in an economy whose exchange rate is substantially free, and contrast the results with those which would obtain under a system with a fixed exchange rate.