The Simple Post-Keynesian MonetaryPolicy Model: An Open EconomyApproach

LEONARDO VERAUniversidad Central de Venezuela, FACES-Escuela de Economıa, Caracas,Venezuela

(Received 14 June 2012; accepted 4 June 2013)

ABSTRACT Monetary policy with an inflation targeting rule is analyzed through a simplesmall-scale Post-Keynesian model that incorporates open economy issues. In contrastwith previous Post-Keynesian attempts, the model embodies policy authorities that arecommitted not only to hitting inflation and/or output targets, but also to theachievement of the external balance. To take account of the external balance objective,we model the real exchange rate as an endogenous and moving target, with thenominal exchange rate being the instrument of that target. The model shows that inresponse to an adverse external shock the central bank has to consider first therequired real exchange rate adjustment that will preserve the external balance, andsecondly the level at which the interest rate must be set in order to maintain inflationstabilization. Keeping inflation to target requires higher interest rates and strongreliance on the unemployment channel which, under certain circumstances, also hasadverse side effects on income distribution. We show that to deal with an exogenousexternal shock a policy mix of real exchange rate targeting and income distributiontargeting outperforms inflation targeting.

1. Introduction

During the last several decades macroeconomic analysis and policy have beendominated by a narrow and pronounced concentration on the foundations and use-fulness of monetary policy. The so-called New Consensus approach to macroeco-nomic policy has wrongly spread the idea, among both economic analysts andpolicy-makers, that the focus of macroeconomic policy must be on price stability,that lower inflation can be achieved without any loss of output, and that monetary

Review of Political Economy, 2014

http://dx.doi.org/10.1080/09538259.2014.969547

Correspondence Address: Leonardo Vera, FACES- School of Economics, Ciudad Universitaria,Caracas 1050, Venezuela, E-mail: leonardo.vera@cantv.net

# 2014 Taylor & Francis

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policy can efficiently be conducted through the implementation of an inflationtargeting framework.1 Thus, the major policy prescription closely associatedwith the New Consensus is inflation targeting. Monetary targeting, introducedby the United States and the United Kingdom in the mid-1970s and transferredto many developing countries in the 1980s through the IMF-supported programs,has either been downplayed or abandoned.

Although inflation targeting is amonetary policy framework that places severaldemands and requirements on central banks, its theoretical foundation can be easilysummarized in a simple small-scale macroeconomic model. The hallmark of thisconventional or New Consensus macroeconomic modeling is the embodiment ofvery well known (but very often hidden) classical principles: supply-determinedequilibrium and demand-pull inflation. Essentially in their small-scale models aswell as in their more sophisticated dynamic stochastic general equilibrium(DSGE) models, the New Consensus approach to monetary policy rests on a formof the classical dichotomy whereby there is a separation between the real side ofthe economy (effectively described by the supply-side equilibrium) and the monet-ary side of the economy (specifically the demand side in the form of interest rates).As Arestis & Sawyer (2008) have correctly remarked, this separation allows theassignment of monetary policy to the nominal side of the economy, and specificallyto inflation, leaving the supply-side policies to address the real side of the economy.But while the classical dichotomy was developed in the early 20th century in thecontext of exogenous money and the application of the quantity theory of money,today, under the New Consensus approach, the focus of the dichotomy has shiftedto the notion of varying the key policy interest rate. Two tentative but feasiblereasons that may explain this change of view among mainstream economists are:themore explicit and public character of central bank procedures, and the increasingpopularity of simple ‘leaning-against-the-wind’ interest rate rules such as the oneformulated by John Taylor (1993) almost two decades ago.

The New Consensus approach is certainly on the right track when it recog-nizes that in macroeconomic modeling, monetary policy can be summarized interms of an interest rate policy reaction function and that under an interest ratepolicy rule the money supply is endogenous—a requirement upon which Post-Keynesians have long insisted. It would be misleading, however, to suggest thatin its approach to monetary policy the New Consensus offers revolutionaryideas or results; for its baseline model is still imbued with many familiar classicalmacroeconomic properties.

In recent years, Post-Keynesian economists have reacted by criticizing theNew Consensus approach and its baseline model for a variety of reasons. Thearguments are well summarized in the first part of Lavoie & Seccareccia(2004), Kriesler & Lavoie (2007) and Arestis & Sawyer (2008), but the literature

1According to Hammond (2011), at the start of 2011, some 27 central banks could be consideredfully-fledged inflation targeters, and many others were in the process of establishing a fullinflation-targeting framework. Member countries of the European Monetary Union, Hammondnotes, do not belong to the universe of inflation targeters. The set of countries using inflation target-ing as their main monetary policy frameworks accounts for about 25 per cent of world GDP.

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is vast and much of it is documented and cited in Asensio & Hayes (2009), Hein,Niechoj & Stockhammer (2009) and Hein & Stockhammer (2010). Although stillin an incipient stage, recent work undertaken by Post-Keynesian economistsutilizes less conventional and more relevant real-world alternative models toanalyze monetary policy with inflation targeting and other monetary rules.Some remarkable efforts in this direction can be found in the works of Setterfield(2004), Lavoie (2006), Atesoglu & Smithin (2006), Rochon & Setterfield (2007),Setterfield (2007), Lima & Setterfield (2008), Setterfield (2009) and Hein &Stockhammer (2010). An interesting characteristic of these formal analyticalefforts is that though most of the models are relatively simple, they carry aconsiderable theoretical content and provide a stylized representation of themonetary policy transmission mechanism. Moreover, they are easily understood,and especially suitable for simulation of a wide range of issues.

Most these Post-Keynesian models deal with closed economies.2 Yet most ofthe real-world economies that target inflation are open economies with unrest-ricted capital mobility, where shocks originating in the rest of the world are impor-tant (and very often unpredictable), and where the exchange rate plays a prominentrole in the transmission mechanism of monetary policy.3 In a world of widespreadfinancial openness and capital mobility, inflation targeters have come to realizethat large and frequent external shocks (mostly financial shocks), have tendedto make the external accounts potentially more unstable and that the exchangerate may therefore play an important role in the conduct of monetary policy.Post-Keynesian economists have certainly made some efforts to extend theirmacro-models of income distribution and growth to an open economy framework.The work of Lance Taylor (e.g. 1988, 2004), Sarantis (1990–91), Blecker (1989,1999, 2011), Cassetti (2002) and Missaglia (2007) are notable examples.However, none of these works deals explicitly with short-run monetary policyissues or inflation targeting rules, and they lack a good representation of the inter-est rate and exchange rate operating procedures that may be crucial for small openeconomies today.

The main purpose of this paper is to extend the formal monetary policy analy-sis of the simplest small-scale Post-Keynesian macroeconomic model and thenevaluate the way in which external shocks can affect monetary policy, as wellas the impact of monetary policy reactions on macroeconomic performance. Anessential difference with the previous Post-Keynesian literature is that our basic

2Two rare exceptions are Cordero (2008) and Porcile, Gomes Da Silva & Viana (2011) who developformal monetary policy models in which the nominal interest rate is chosen to hit either an inflationtarget or a real exchange rate target. However, both attempts concentrate on the comparison of twoalternative monetary regimes: inflation targeting versus real exchange rate targeting. Their approachtherefore avoids interactions among macroeconomic policy instruments and the possibility of con-flicting targets, a pattern that differs from the one we follow here.3Edwards (2006, p. 2), discussing whether the exchange rate should affect the monetary policy rulein inflation targeting countries, observes that ‘almost every central bank takes exchange rate behav-ior into account when undertaking monetary policy.’ Aizenman et al. (2011, p. 713) similarly remarkthat ‘Real exchange rates are likely to play an important role in the formulation of optimal monetarypolicy in emerging markets’.

The Simple Post-Keynesian Monetary Policy Model 3

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model embodies policy authorities that are concerned not only with inflation oroutput targets, but also with the achievement of external balance.4

We lay out a small open-economy version of the closed-economy modeldeveloped by Setterfield (2007) and Rochon & Setterfield (2007) and use it toanalyze the macroeconomic implications of an adverse external shock. One ofthe main advantages of this framework is the very rich set of endogenous variablesthat can absorb the various impacts of monetary policy. Indeed, not only do small-scale monetary policy models of the type developed by Setterfield and Rochonallow the traditional evaluation of inflation and output effects of monetarypolicy, but they can also bring to light the distributive implications for differentgroups within the economy.5 Most importantly, we model the real exchangerate as an endogenous and moving target, with the nominal exchange rate beingthe instrument of that target. Thus, when we address the issue of an externally-induced disequilibrium in the balance of payments, the simple rule followed bythe monetary authority—under a managed float—is to intervene on foreignexchange markets and to promote the required real exchange rate adjustmentthat allows the restoration of the external balance. In the particular case of a nega-tive external shock, which entails both nominal and real exchange rate deprecia-tions, the adjustment of the nominal exchange rate will affect both the equilibriumrate of inflation and the equilibrium wage share, while the real exchange rateadjustment will have real effects, in particular on the rate of unemployment. Ifthe monetary authority also targets inflation, the higher level of inflationinduces an adjustment in the domestic interest rate that will have furtherimpacts on inflation, unemployment and the distribution of income.

We employ our framework to show that while the preservation of the externalbalance requires real exchange rate adjustments, the central bank will also have toconsider what the interest rate must be set to, in order to maintain inflation stabil-ization. However, keeping inflation to target requires higher interest rates andstrong reliance on the unemployment channel, which has adverse side effectson employment and income distribution. We then consider the arguments for adifferent policy mix in which real exchange rate targeting is combined withincome distribution targeting. The analytical results suggest that it may be advisa-ble to evaluate alternative policy interventions such as this. With monetary policyappropriately ‘parked’, the nominal exchange rate should move to hold the realexchange rate in the vicinity of a balanced external sector, and incomes policiescan preserve a more equitable distribution of income, so that a low level ofinflation is sustained while the disciplinary effect of unemployment is avoided.

The remainder of the paper is organized as follows. In Section Two we lay outthe structure of the model. Section Three derives the equilibrium rates of inflationandwage share from the inflation-generating process of themodel. It then examines

4From a macroeconomic point view addressing the external balance is equivalent to addressing thecompetitiveness issue.5This is done through the inclusion of a two-equation dynamical system that describes the wagebargain and price setting process of organized workers and firms in terms of conflicting claimsover the distribution of income. The system allows the endogenous and simultaneous determinationof the equilibrium rate of inflation and the equilibrium wage share.

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the effects of an exogenous variation in the nominal exchange rate on the equili-brium. Section Four analyses the macroeconomic implications of an adverse exter-nal shock and shows monetary policy reacting to the external disequilibriumthrough the promotion of real exchange rate depreciation, and to the higher rateof inflation, through the interest rate operating procedure. In Section Five we intro-duce the idea that workers’ bargaining power is a decreasing function of the rate ofunemployment, allowing the monetary authority to recover its influence over therate of inflation. The analysis suggests that the disciplinary device of unemploymentmay yield better inflation stabilization results; however, inflation targeting mayhave a negative impact not only on unemployment but also on the distribution ofincome. In Section Six, a diagrammatic representation of the model is used toshow that a policy mix of real exchange rate targeting and income distribution tar-geting outperforms inflation targeting as away of dealing with an exogenous shock.

2. The Model

The model builds on some of the key features found in Rochon & Setterfield(2007) and Setterfield (2007), insofar as it includes an inflation-generatingprocess, an IS relation (or an income-generating process) and an interest rate oper-ating procedure (IROP). We build on this earlier work by integrating the externalsector as well as an exchange rate operating procedure (EROP) into the model.Thus, being an open economy characterization, the model also allows a pass-through from the rate of growth of the nominal exchange rate to price inflationand effects on effective demand (or real effects) through variations in the realexchange rate. Moreover, in this economy the role of the monetary authoritycan be confined to setting the target inflation rate and/or the target real exchangerate. This means that with more than one target, the monetary authority has to dealwith the possibility of new partially conflicting macroeconomic objectives and, aswe will see, this is due to the fact that monetary policy actions in the prosecution ofmultiple objectives are interconnected and have to be coherently designed.

The basic model can be described by the following equations:

w = m1(vW − v) + m2pe; 0 , mi , 1 (1)

p = f1(v− vF) + f2(w− a) + f3e; 0 , wi , 1 (2)

U = g1 + g2r − g3q; g1, g2, g3 . 0 (3)

BP = BP(qT, z) = 0; dBP/dqT . 0 (4)q = e pf

p(5)

e = a(qT − �q); a . 0 (6)r = r0 + d(p− pT); d . 0 (7)

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Equations 1 and 2 describe nominal wage and price inflation. In effect, theseequations form a sub-system that characterizes the inflation-generatingprocess. The sub-system follows closely the one found in Rochon & Setterfield(2007), Setterfield (2007), Lima & Setterfield (2008) and Rochon & Setterfield(2011), but it also includes the exchange rate channel in the analysis of theinflationary process.

More specifically, in Equation 1 the rate of growth of nominal wages, w, isdetermined within a conflicting claims framework, with wage inflation resultingwhenever income claims of workers as a share of total income, vW, exceed theactual wage share, v. Expression 1 also indicates that wage inflation has an expec-tations-augmented component pe. We assume that the parameters mi in Equation 1are between zero and one, meaning that wage indexation is incomplete.6 The par-ameter m1, in particular, reflects the relative power of workers vis-a-vis firms in thewage bargain. In contrast to Rochon & Setterfield (2007, 2011) and Lima & Set-terfield (2008) we do not find it convenient or even necessary to assume that mi ¼mj for all i, j.

Equation 2 describes the determination of price inflation as a result of threefactors. The first factor captures the distributional conflict (among firms andworkers) and suggests that firms will find it in their interest to initiate priceincreases whenever the actual wage share v is greater than their target for thewage share, vF. This is the formulation used by Rowthorn (1977) in hisseminal work on conflict inflation; it is also found in Flaschel & Kruger (1984)and Dutt (1990, 1992). The second and third factors suggest that firms may beable to pass on increases in the rate of growth of unit labor cost, w− a, andnominal exchange variations, e, to consumers. The parameters wi are againassumed to be between zero and one and in general wi = wj for all i, j. A keydifference between this simple Post-Keynesian model and the New Consensusalternatives is that the former contains no Phillips curve embodying the naturalrate hypothesis.

The relationship between aggregate demand and real activity is captured byEquation 3, in which the rate of unemployment,U, is a linear function of the short-run interest rate, r, and the real exchange rate, q. As in Rochon & Setterfield(2007), the income distribution channel is omitted to avoid simultaneitybetween the inflation-generating process and the determination of real outcomes.7

An increase in the interest rate presumably will increase the rate of unemployment

6Palley (2011) points out that there is a long history of empirical support for the proposition that thecoefficient of inflation expectations in Equation 1 is less than unity.7Hence, to preserve the tractability of the model we incur one cost: the omission of the distributivechannel. The presence of the terms g1 in Equation 3 is meant to capture all factors that, abstractingfrom the interest rate and exchange rate channels, can influence aggregated demand and employ-ment; but it is clear that it cannot capture the endogeneity of the rate of unemployment withrespect to changes in the wage share. One of the consequences this strategy, and in clear contrastwith Neo-Kaleckian models, is that it is not possible to designate an open economy as havingwage-led or profit-led demand regimes as do Neo-Kaleckian models.

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while a rise in the real exchange rate can help boost employment.8 The term, l1, inEquation 3 reflects the impact of factors other than these two variables on aggre-gate demand and hence unemployment.

In Equation 4, the term BP(.) denotes the balance of payments as a func-tion of the real exchange rate and a vector z composed of elements{z1, z2, . . . },each of which corresponds to some exogenous external variable, such as thelevel of foreign interest rates, short-term portfolio investment, the availabilityof foreign financing and so on.9 Then BP(.) ¼ 0 represents equilibrium in thebalance of payments. In such a context, for given values of z there will be aparticular value of the real exchange rate that allows external balance. Wecall that rate the real exchange rate target, qT. A depreciation of the realexchange rate will improve the balance of payments since it could be associatedwith the conventional price-related switch of demand away from imports andthe additional incentives to supply exports provided by the increase in theirdomestic currency supply price. If the economy is, for instance, hit by anadverse foreign shock, the restoration of the balance of payments equilibriumrequires a higher real exchange rate target. Thus, the real exchange ratetarget is an endogenous variable (or a moving target) tied to the overall situ-ation in the balance of payments.

In Equation 5, the real exchange rate is defined as the nominal exchange rate,e, adjusted by the ratio of the single good foreign price level (an exogenous vari-able), pf, to the domestic price level, p.

We turn now to Equations 6 and 7, which describe the conduct of monetarypolicy as a result of an IROP and an EROP. In Equation 6, the nominal exchangerate reacts to deviations between the real exchange rate target and the long-runequilibrium real exchange rate �q. Presumably, in a managed float system, e willadjust as much as is needed to move the current real exchange rate rapidlytoward the central bank’s target. Thus, through foreign exchange market interven-tions a central bank exchanges foreign sight deposits against domestic centralbank reserves in order to target the exchange rate.10 In contrast, the convergence

8Frenkel (2004) summarizes a number of recent empirical studies of Latin American countries inwhich real exchange rate depreciations and the rate of employment are positively related. Zenget al. (2011) find similar results for China.9Beyond the uncontroversial treatment of the foreign interest rate as exogenous, we also assume thatcapital flows, whatever form they may take, are explained by conditions outside the domesticeconomy. Indeed, co-movements of capital flows across countries, or ‘contagion’ effects, canhardly be explained by return differentials or expected rates of return. An early assessment of therole of external factor accounting for the observed capital flows in Latin American countries canbe found in Calvo et al. (1993). Taylor & Sarno (1997) investigate the determinants of large portfolioflows from the US to Latin American and Asian countries during 1988–1992 and find that ‘globalfactors are much more important than domestic factors in explaining the dynamics of bond flows’(Taylor & Sarno, 1997, p. 451).10There are good reasons to presume that this is how most floating systems work in practice today. Ina fully flexible system, as the experience in mature and developing countries has shown, speculationmay be destabilizing in the sense it may cause the exchange rate to diverge from the rate that wouldassure balance of payments equilibrium. It is this risk of destabilizing speculation that explains whymost countries that declared themselves to be independent floaters in the IMF statistics actually inter-

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between the real exchange rate target and the long-run rate is slow. Therefore, it isonly in the long run that the real exchange rate will converge to a constant valuethat may be consistent with Purchasing Power Parity. In addition, Equation 7introduces a variant of the Taylor rule in which monetary policy also acts onshort-run nominal interest rate in response to any departure of the actual rate ofinflation, p, from the central bank’s target, pT. Note that monetary aggregatesare conspicuous by their absence from Equation 7, which assumes that theconduct of monetary policy is characterized by an IROP.

3. The Inflation-Generating Process

In the New Consensus in macroeconomics it is quite common to express labormarket and goods market dynamics by a single representation of the Phillipscurve, with demand pressure based on the evolution of the labor market andwith additional pressures represented by a single expected rate of inflation. ThePost-Keynesian alternative that we specify here includes two equations inwhich conflicting income claims, cost pressures and expected inflation regulatethe joint dynamic evolution of wages and prices.

From Equations 1 and 2, and in the spirit of Lavoie (1992, ch. 7), we canobtain an equilibrium configuration for the rate of inflation and the share ofwages in gross output. The equilibrium is achieved when two further conditionsare satisfied. The first implies the realization of inflation expectations, that isp = pe. Secondly, in steady state equilibrium, the wage share should be constant,which (from the definition of the wage share) implies that p = w− a. Substitutingthese conditions in Equations 1 and 2 and rearranging yields

p = m1(vW − v) − a

(1− m2)(8)

p = f1(v− vF) + f3e

(1− f2)(9)

Combining Equations 8 and 9 we get the equilibrium wage share

v∗ = (1− m2)f1vF + (1− f2)m1vW − (1− f2)a− (1− m2)f3e

[(1− m2)f1 + (1− f2)m1](10)

The reader may note that since v∗ is constrained to be positive, then thefollowing condition regarding the numerator in Equation 10 should besatisfied: (1− m1)w1vF + (1− w1)m1vW . (1− w2)a− (1− m2)w3e. Differen-tiating Equation 10 with respect to variations in the nominal exchange rate, we

vened in the foreign exchange market, often on a large scale and on a regular basis (Bofinger &Woll-mershauser, 2003).

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get an inverse relationship between e and v∗. That is

dv∗

de= −(1− m2)f3

[(1− m2)f1 + (1− f2)m1], 0 (11)

Substitution of Equation 10 into Equation 8 allow us to obtain the equilibrium rateof inflation p∗, that is the rate of inflation that is consistent with steady state equi-librium and that is obtained when inflation expectations are realized and the wageshare is constant. This yields

p∗ =m1 vW − (1− m2)f1vF + (1− f2)m1vW − (1− f2)a− (1− m2)f3e

[(1− m2)f1 + (1− f2)m1][ ]

− a

(1− m2)(12)

Remarkably, but maybe not surprisingly, when conflict over the distribution ofincome is absent (vW ¼ vF) and the context that prevails is one of time-invariantlabor productivity (a = 0) and nominal exchange rate (e = 0), the equilibrium rateof inflation will be zero (p∗ = 0).

Expression 12 also provides information on the effects of nominal exchangerate adjustments on the equilibrium rate of inflation.

dp∗

de= m1f3

[(1− m2)f1 + (1− f2)m1]. 0 (13)

How do nominal exchange rate changes pass through into changes in the domesticprice level? In Equation 13 the answer depends very much on the values of m1 andw3. For instance, as w3 � 0, the pass-through of exchange rates to prices will beincomplete, meaning that the value of dp∗/de will be between zero and one. Thereader may note immediately that in such a case the real exchange rate would notbe constant, and the law of one price would not hold. Indeed, there is a substantialbody of empirical evidence covering many countries that reports low exchangerate pass-through or a weak association of exchange rate adjustments withchanges in domestic prices at the consumer level (see Engel, 2002; Devereux &Yetman, 2002; Edwards, 2006).

Summarizing, the inflation-generating process described by the wage andprice inflation expressions, Equations 1 and 2, helps determine the equilibriumwage share and the equilibrium rate of inflation, and both solutions are affectedby changes in the nominal exchange rate in very specific ways.

Following Rochon & Setterfield (2007) we can obtain a geometric represen-tation of the equilibrium solutions for v and p that also enables us to see the impact

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of a devaluation episode. Rearranging Equations 8 and 9 we obtain a represen-tation, in the p− v space, of the inflation generating process.

p = m1vW − a

(1− m2)− m1

(1− m2)v

dp

dv PW|= − m1

(1− m2), 0

(14)

p = f3e− f1vF

(1− f2)+ f1

(1− f2)v

dp

dv PF|= f1

(1− f2). 0

(15)

Equation 14 captures the wage bargaining process and 15 the price setting process.In Figure 1, the negatively sloped schedule pw depicts Equation 14 and the posi-tively sloped schedule pF the relationship between v and p associated with theprice setting process. These two schedules combine to yield equilibrium valuesfor the rate of inflation and the wage share. Now, assuming that we are originallyin equilibrium, we will expect an exogenous increase in the rate of growth of thenominal exchange rate (e) to shift the pF schedule to the left. We can see that theresult is to shift the equilibrium to point B, thereby causing equilibrium inflation toincrease and the equilibrium wage share to decrease.

Having established these results, it is useful to substantiate the assumedincrease in the rate of growth of the nominal exchange rate and evaluate itsimpacts on the rest of the endogenous variables.

Figure 1. The inflation-generating process and the impact of devaluation

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4. The Complete Model in Motion and the Impact of an ExternalShock

In an open economy central banks may pay attention to external developmentsin at least two ways. Central banks adopting, for instance, inflation targetingargue that they care about the exchange rate only to the extent that it has animpact on their primary objective, the control of inflation. This is certainlythe case in large advanced economies where the foreign exchange constraintis not a threat (or it is not binding). For smaller countries, however, experiencesuggests that in fact many of them pay close attention to the external balanceand also intervene on foreign exchange markets to influence both nominal andreal exchange rates. A fundamental point, in this latter case, is that by influen-cing the exchange rate, policy-makers may cause the current or actual rate ofinflation to deviate from the target. Hence, close attention to the externalbalance will affect domestic inflation and the appropriate monetary policyresponse under inflation targeting.

Variations in the nominal exchange rate may now be explained. Let’s startwith Equation 4, which represents the external balance and, in particular, the equi-librium in the balance of payments for given values of qT and z. A linear specifica-tion of Equation 4 may be

BP = s1q+ z; s1 . 0 (4a)External balance (BP ¼ 0) will require

qT = − 1

s1

z (16)

Now let us assume that the economy is hit by an adverse external shock such as acut in foreign capital flows. If the economy is foreign exchange constrained, thefall in z requires a restoration of the balance of payments equilibrium and thisin turn requires a higher real exchange rate target qT which, given the expressionderived above, implies that

dqT

dz= − 1

s1

, 0

Therefore, if the monetary authorities decide to restore the external balance, theywould set a higher value for the target real exchange rate and through Equation 6the nominal exchange rate would presumably depreciate.

The proposal here is that monetary authorities intervene more or less system-atically in the exchange rate markets and by selling lower amounts of foreignassets help support the increase in the nominal exchange rates. In order to demon-strate the full impact of the fall of z on the behavior of the nominal exchange rate,e, we substitute Equation 16 into Equation 6 and this yields

e = −a1

s1

z+ �q

( )(17)

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Inspection of Equation 17 reveals that for a given �q the motion of the nominalexchange rate is governed by the new target exchange rate, which ultimatelydepends on changes in z. From Equation 5, the immediate impact of thenominal exchange rate adjustment will be an increase in the real exchange rate,q. However, the higher e will have an impact on the equilibrium rate of inflationas given by Equation 13 and this feeds back into real exchange rate adjustments(so that the effect on q might be, in principle, unknown). Assuming that pf ¼ 1,depreciation of the real exchange rate requires de . dp. In spirit, this is perfectlyconsistent with the incomplete pass-through implied by the model.

A graphical representation could illustrate how an adverse external shockproduces an adjustment in the target real exchange rate and accelerates inflation.Substituting Equation 6 into Equation 12 yields a relationship between the equili-brium rate of inflation and the real exchange rate target. This is given by

p∗ =

m1 vW −(1− m2)f1vF

+(1− f2)m1vW − (1− f2)a− (1− m2)f3a(qT − �q)[(1− m2)f1 + (1− f2)m1]

⎡⎢⎢⎣

⎤⎥⎥⎦− a

(1− m2)(18)

Differentiating with respect to qT yields

dp∗

dqT= am1f3

[(1− m2)f1 + (1− f2)m1]. 0

In Figure 2(a), the upward-sloping schedule VV represents Equation 18. It is drawnassuming that 0 , dp/dqT , 1 for given values of vW, vF and a. The verticalschedule BP represents the external balance BP(qT, z) ¼ 0, drawn for a givenvector z. In this setting, an exogenous and adverse external shock affecting thebalance of payments will shift the BP schedule rightward, thus increasing the equi-librium real exchange rate target and the equilibrium rate of inflation. In panel (b)of Figure 2, the leftward shift of the pF schedule is now fully justified by the exter-nal event.

At this point, it is worth calling attention to two further impacts associatedwith the increase in the equilibrium rate of inflation, p, and in the real exchangerate, q. First, as long as p . pT, the monetary authority will certainly respondwith an increase in r, which from Equation 3 will increase the rate of unemploy-ment. Secondly, the higher level of competitiveness not only improves the balanceof trade but also boosts output and lowers the rate of unemployment. Thus, in thecurrent model, it is not obvious what happens to unemployment when theeconomy is hit by an adverse external shock.

The adjustment process of the rate of unemployment can be described withthe help of Figure 2. As before, Equations 14 and 15 are drawn in Figure 2(a),

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and Equations 4 and 12 are drawn in Figure 2(b). The inverse relationship betweenthe rate of unemployment and the real exchange rate, as given by Equation 3, isnow represented in panel (c) in Figure 2 by the NN locus. Notice that althoughthe increase in the equilibrium real exchange rate will have a positive effect onemployment, the higher equilibrium rate of inflation will induce an increase inthe policy-controlled interest rate. As the interest rate increases, the NN locusshifts out to NN′ as described by the dotted line in panel (c). Visually, thewhole adjustment that we have represented is a move of equilibrium from pointA to point B in Figure 2(c), in which the unemployment rate seems to be unaf-fected by the rise in qT and r.

Thus, the analysis shows that any negative disruption of the exogenous com-ponent of the balance of payments redistributes income from workers to firms,accelerates inflation, but has an ambiguous effect on the rate of unemployment.Somehow, what makes this adjustment process unique is that the monetarypolicy rule only affects aggregate demand and unemployment, but cannot be

Figure 2. The impact of an adverse external shock on the rate of unemployment

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used to target inflation or income distribution since the final link in the chain, thePhillips curve, is absent.

5. The Case in which Worker Bargaining Power Is Endogenous

The preceding analysis pertains to a short-run situation in which inflation is unaf-fected by the behavior of real variables such as the rate of unemployment, GDPgrowth or any proxy for aggregate demand. Beyond the conflicting claims basisof the inflation process Post- Keynesian economists recognize the importance ofthe aggregate demand conditions. However, formalizations of the inflationprocess in which the inflation rate is positive whenever the output demandexceeds the ‘normal’ or potential level of output, are rejected (see for instance,Kriesler & Lavoie, 2007; Palley, 2006; Arestis & Sawyer, 2008). The problemis that in the mainstream view both the theoretical content and the policy approachto deal with the inflation process are still situated within a NAIRU-based macro-economic framework.11 For Post-Keynesians, this is highly problematic sinceNAIRU is grounded in a supply-side driven theory of macroeconomics inwhich inflation (in the absence of excess demand pressures) converges to anoptimal level, monetary policy is neutral in the long-run, and the level of unem-ployment (and the optimal level of inflation) depends on the institutions and theoperation of labor markets.

Post-Keynesians generally treat unemployment, output growth or evencapacity utilization as the ultimate determinant of demand-driven inflation, butfor reasons that deeply differ from mainstream views. For Post-Keynesians thedistribution of power among worker and firms (for instance) will change withthe economic cycle. Following Rowthorn (1977), it is now common in Post-Key-nesian macro-models to see the inflation-generating process affected by therelationship between workers’ bargaining power and rate of unemployment. Inessence, unemployment may act as a regulator of ‘class conflict’. In Rowthorn’swords:

Demand functions as a regulator of class conflict. On the workers’ side a lowlevel of demand isolates militants from the mass of workers and strengthensthe hand of ‘moderate’ leaders against dissenting elements. On the employers’side it reduces their ability to raise prices and may force them to revise down-wards their target profit margins (Rowthorn, 1977, p. 237).

Rochon & Setterfield (2007) formulate an expression that ultimately rendersconflicting-claims inflation amenable to change by aggregate demand.12

m1 = m1(U); dm1/dU , 0 (19)

11Although the NAIRU has receded as a concept for guiding policy and has been increasinglyreplaced by the notion of inflation targeting, it still underlies the inflation-generating process ofmainstream macroeconomic models.12Setterfield (2007) uses a more complex specification in which workers’ bargaining power is alsoaffected by institutional changes in the labor market that create income insecurity or employmentinsecurity among the working class.

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In Equation 19, workers’ bargaining power is decreasing in the rate of unemploy-ment. Thus, the inflation-generating process is now portrayed as affected by therate of unemployment and ultimately by both the nominal interest rate and thereal exchange rate, as seen in Equation 3.

Since we have deduced the equilibrium solutions for the wage share and therate of inflation, it is easy to find the impacts of a change in workers’ bargainingpower. But first note that in Equation 10 both the numerator and the denominatormust have positive values (since a negative wage share is meaningless). Moreover,the former should be lower than the latter (since the equilibrium wage share inincome is by definition between zero and one). Formally both terms can bedenoted as:

G = (1− m2)f1vF + (1− f2)m1vW − (1− f2)a− (1− m2)f3e . 0

D = [(1− m2)f1 + (1− f2)m1] . 0

in which D . G holds. Differentiation of Equations 10 and 12 with respect to m1

then yields

dv∗

dm1

= (1− f2)vWD− (1− f2)GD2

(20)

dp∗

dm1

= vW

(1− m2)− G

(1− m2)D− (1− f2)vWD− (1− f2)G

D2

[ ]m1

(1− m2)(21)

It follows that the signs in both expressions are indeterminate. By combining theseresults with Equation 19, we will arrive at a position in which we cannot make anycategorical assertion regarding the effects of a change in the rate of unemploymenton the equilibrium wage share and the equilibrium rate of inflation. Formally wehave

dp∗

dU= ∂p∗

∂m1

dm1

dU+/−( )

dv∗

dU= ∂v∗

∂m1

dm1

dU+/−( )

In essence, it all depends on the structure of the economy, which is summarized bythe coefficients of the behavioral functions in each partial derivative. But it shouldbe noted that, from a Post-Keynesian perspective, the flexibility of the model is agreat advantage.

We provide two contrasting examples of this advantageous flexibility. In ourfirst approximation, the monetary authority, still facing a foreign exchange con-

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straint (and the need for a real exchange rate depreciation), also cares about therate of inflation and reacts accordingly. We may depict the set of solutions forthe model’s equilibrium geometrically as in Figure 3.

In the upper left panel of Figure 3 the BP schedule shifts to the right as aresult of the adverse external shock and the commitment of the monetary auth-ority to equilibrate the balance of payments. The pF schedule immediatelyaccommodates itself to the nominal exchange rate adjustment; this is shownin panel (b) of Figure 3. These developments unambiguously accelerate therate of inflation. The monetary authority may now try to offset the inflationaryeffect of the exchange rate depreciation by increasing the short-run interest rateand reducing aggregate demand and employment. Notice, that despite theexpansion in domestic output and employment generated by the depreciationof the real exchange rate, this does not mean that the monetary authoritywill necessarily fail in achieving an increase in the rate of unemployment.The lower panel of Figure 3 shows that even with the expansionary realexchange rate adjustment (which moves qT from qT1 to qT2 ), the rate of unem-

Figure 3. The impact of an adverse external shock when workers’ bargaining power is endogenous

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ployment rises to U2 as the NN schedule shifts upward and to the right. Thedistributive and inflationary impacts of a change in the rate of unemploymentcan now be examined by considering the effects of such a change on the pos-ition of the pw schedule in panel (c). Following Equation 19, the increase in therate of unemployment reduces workers’ bargaining power and this reduction inm1 in turn affects both the slope and the intercept of the pw schedule (bothdiminish). The shift in the intercept downwards against a less steep pw scheduleresults in a modest decrease in the equilibrium wage share and a failure tostabilize inflation. Since the still higher level of inflation is achieved withoutany further change in qT, the VV schedule shifts and rotates clockwise toVV′, as captured in the left-hand panel (a) of Figure 3. The reader shouldrealize that this failure to bring the inflation rate back to the target is fully con-sistent with a short-run equilibrium. In the long run, some kind of dynamics,

Figure 4. The impact of an adverse external shock when workers’ bargaining power is endogenousand monetary policy stabilizes inflation

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not explored here, may lead the interest rate r to its long-run value r0 andpT = p.13

This analysis suggests that a different set of behavioral parameters represent-ing the response of the labor market to the disciplinary device of unemploymentmay yield better inflation stabilization results. This case is presented in Figure 4.Once again, to offset the inflationary effect of the exchange rate depreciation, themonetary authority seeks to engineer an increase in the rate of unemployment. Fol-lowingEquation 19, the increase in the rate of unemployment reducesworkers’ bar-gaining power, but this time m1 is more elastic with respect to the disciplinaryimpact of unemployment than in the previous case. The reduction in m1 affectsboth the slope and the intercept of the pw schedule in panel (b) and, since the unem-ployment effect on worker’s bargaining power is strong, the rotation of the pw sche-dule will be large and it is more likely that the wage share will fall and the rate ofinflation will move back toward the target (at point B).

In sum, if the conservation of the external balance involves an adjustment inthe real exchange rate target, then the central bank will carefully have to considerits inflationary impact and will need to determine the level at which the interestrate must be set in order to maintain inflation stabilization. However, keepinginflation to target requires strong reliance on the unemployment channel, whichhas adverse side effects on employment and income distribution.

6. Nominal Stabilization with Income Distribution Targeting: Isthere a Role for Incomes Policies?

The problem with strict inflation targeting leads us to suggest a modification.While a more orthodox approach recognizes exchange rate targeting (to restorethe external balance) and includes inflation targeting as part of stabilization, wepropose a heterodox approach that emphasizes real exchange rate targeting butcombined with income distribution targeting. Thus, the overriding lesson fromthe analysis that follows certainly includes the need for relative price adjustmentto maintain external competitiveness, but it also indicates the need to recognizethat a dose of initial overkill to the working class may not be an inevitable ingre-dient of a successful inflation stabilization effort.

Regarding the role of income distribution targeting, the starting point for thediscussion is the recognition that in an open economy severely affected by a nega-tive external shock, any attempt to restrict demand would translate into changes inthe distribution of income with clear winners and losers. Therefore, insights con-cerning the best way of managing economic policy to avoid inequities deserveattention. But there is a further and no less important point. In a world of pricesetters and wage setters, a large part of any prevailing inflation is essentiallycaused by conflicting claims over the distribution of income, an aspect fully cap-

13This result validates the findings made by Hein & Stockhammer (2010) in their closed economymodel in which inflation-targeting monetary policies—the main stabilization tool proposed by theNew Consensus Model—are in the short-run adequate only for certain values of the model par-ameters.

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tured, in Equations 1 and 2, by the deviation of v from vW or vF. Expressions 1and 2 suggest then that a viable alternative for achieving disinflation is to establishstandards for profit and wage aspirations. This is the direct and explicit role playedby incomes policies.

At the outset, it is necessary to be clear about what is meant by incomes pol-icies here. As Eichner (1985) points out, in a democratic society an explicit andviable incomes policy cannot be imposed. It must instead gain acceptanceamong the different interest groups within the society as a fair and equitablebasis for distributing the social surplus. Accordingly, in our case, incomespolicy is the device by which the government targets income distribution andinflation within a collective bargaining environment. This implies the use of nego-tiated standards for profit and wage aspirations; standards that are operationalizedin the simple Post-Keynesian model through negotiated changes in vW and vF.

14

Of course, the success of incomes policies of this type is tied to the involvement ofboth the labor and business organizations in the design and implementation ofpolicy, and to the capabilities that the government has to manage conflictamong interest groups. As Glyn & Rowthorn (1988) and Rowthorn (1992) havenoted, the social corporatist societies of Northern Europe and their centralized col-lective bargaining systems have achieved a significant measure of success in thisrealm because collective-level negotiations between well-organized employersand trade unions have allowed a greater understanding of the possible risks ofnon-cooperation, including accelerating inflation. Government capabilities areimportant since the problem requires knowledge about how to channel the influ-ence of economic groups into economically fruitful directions—in other words,how to create conditions in which powerful interest groups will be willing tocooperate with each other and with other groups in society.15

The main step now is to evaluate, within the same context of an economy hitby an adverse external financial shock, the policy mix of exchange rate targetingand income distribution targeting. The developments are illustrated in Figure 5, inwhich the central bank, trying to protect the external balance, allows a deprecia-tion of the nominal (and real) exchange rate and shifts the pF curve to the left inpanel (b). At the same time, if the central bank measures are coordinated withother governmental policies, the potential inflationary pressures of the exchangerate depreciation may now be neutralized through incomes policy. This givesrise to a situation under which an established income distribution target isachieved through negotiated and mutually consensual reductions in vW and vF.In Figure 5 we assume that the income distribution target vT is v1. Close inspec-tion of Equations 14 and 15 shows that consensual and coordinated reductions in

14Cultivating more wage or profit share flexibility does not require the destruction of labor unions, orthe use of force against the business enterprise in a way that undermines profitability and the invest-ment climate. It does, however, require that the flexibility be based on a credible and stable compro-mise between labor and capital.15There are three ways in which the government might contribute to the management of conflictbetween conflicting interest groups: by helping to define the bargaining frontier, by providingpublic information relevant to determining the distribution of the gains from agreement, and by con-tributing to its enforcement.

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vW and vF shift both the pF curve to the right and the pw curve to the left, respect-ively, and this in turn allows the return to v1. Therefore, by acting in accordancewith this principle of consensus and coordination, public authorities ensure thatthe income distribution target is part of an aggregate equilibrium configurationtoward which the economy will move following any adverse external shock.Although no inflation target enters into the evaluation of policy options, theimplied equilibrium rate of inflation has now changed. Specifically, it falls to p2as a result of incomes policies. Note, in addition, that since monetary policyinvolves what Rochon & Setterfield (2007) call ‘parking the interest rate atsome predetermined value,’ it follows that the rate of unemployment would besensitive only to the commitment of the central bank to real exchange rate target-ing. Indeed, the decline in the real exchange rate will diminish the rate of unem-ployment.

7. Conclusions

For many emerging markets, and for small open economies in general, there is aneed to improve macroeconomic performance because of these markets’ increas-ing vulnerability to global economic downturns and, in particular, to frequent andlarge externally-induced financial shocks. The increasing vulnerability to externalfinancial shocks has occurred while many countries have embraced inflation tar-geting as a way of conducting monetary policy. In scenarios like these, countriesusing inflation targeting as a guiding framework for monetary policy very oftenimplement it alongside a managed float. As a result, the exchange rate mayplay an important role in the conduct of monetary policy; macroeconomicmodels should take account of this fact. This paper’s extension of a simplesmall-scale Post-Keynesian model shows that exchange rate channels are criticalto evaluating how external shocks can affect monetary policy and the macroeco-nomic performance linked to it. In contrast with most conventional analysis

Figure 5. The heterodox policy mix: real exchange rate and income distribution targeting

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derived from New Consensus models, our framework has relied on four macroperformance criteria: the external balance, the rate of inflation, the rate of unem-ployment and the distribution of income.

Thus, our monetary policy model shows that when the rate of inflation is notresponsive to movements in measures of unemployment, then the required adjust-ment in the real exchange rate and the restoration of the external balance followingan adverse external shock redistribute income from workers to firms, accelerateinflation, and have an ambiguous effect on the rate of unemployment. The disci-plinary impact of the rate of unemployment is fundamental to re-engineer inflationstabilization. When the inflation-generating process is portrayed as affected by therate of unemployment, inflation targeting recovers its well-known stabilizingproperties but at the expense of higher unemployment and a worsening distri-bution of income.

We have placed our model into the same economic context but with a differ-ent policy mix. Our analysis highlights the fact that while real exchange rate tar-geting can cope with potential threats to the external balance, the potentialinflationary pressures of the exchange rate depreciation may be neutralizedthrough incomes policy. Income distribution targeting through negotiated andmutually consensual reductions in income claims may be an effective way tomaintain inflation stabilization without triggering the adverse side effects onemployment and income distribution.

Acknowledgments

I am grateful to the Editor and Roberto Frenkel for suggestions that led toimprovements to this paper. I also wish to thank an anonymous referee for valu-able comments on earlier drafts.

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