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A central bank that adopts a fixed exchange rate system may sacrifice its monetary autonomy in setting its domestic monetary policy. It is sometimes argued that when this is the case, the central bank also gives up the ability to use monetary policy to combat the wage price spiral. The argument goes like this: Suppose the workers demand higher wages and employers give in, but that the employers then raise output prices to cover their higher costs. Now the price level is higher and the real balances are momentarily lower, so to prevent an interest rate rise that would appreciate the currency, the central bank must buy foreign exchange and expand the money supply. This action accommodates the initial wage demands with money growth and the economy moves permanently to a higher level of wages and prices. With a fixed exchange rate there is thus no way on keeping wages and prices down". What is wrong with this argument?

Microeconomics, Economics

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