Flexible Exchange Rates and Employment Policy

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 government 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.