EXCHANGE-RATE POLICY, UNION WAGE INDEXATION AND CREDIBILITY

Optimal exchange rate regimes for small open economies with economy-wi de wage setting and privately optimal wage indexation schemes are anal ysed. A fully discretionary. exchange rate regime (a managed float) of fers flexibility while a credible fixed exchange rate regime offers pr ice stability. Due to the time-inconsistency problem optimal wage inde xation under a managed float may imply complete indexation of wages to prices. A managed float is shown to be unambiguously superior to a bi nding fixed exchange rate regime if wage setters value price stability as high as the policy-maker does.