Devaluation Cycles as an Implicit Contract

Working Papers 120 Kiander Jaakko

The purpose of this paper is to present a positive theory of devalution cycles. In the model a devaluation cycle is an outcome of a noncooperative game. Workers and employers of export industry bargain over exchange rate and nominal wage adjustments under volatile export price. According to a “mainstream” view the workers should be indifferent between cuts in nominal wage or increased price level through a devaluation. The present model includes net financial assets of workers and firms as arguments in their objective functions. It is shown that trade union is not only interested in the changes of real wage but also on the changes of net real assets since that determines the net disposable income. The firm´s behavior is assumed to be sensitive to its financial position, too. How this debt-factor affects the union´s and firm´s choices between wage and exchange rate adjustments will be examined in detail in the paper. The analysis is also extended to the determination of long-term growth. If flexible exchange rate policy succeeds to limit the volatility of output and profits, then it will effectively decrease the riskiness of investment, and hence promote growth.