11
Treadgold (1992) provided a critique of Khatkhate and Short, and extended Corden’s
model to suit the conditions of small Pacific Island economies. To begin with, a number
of Caribbean and Pacific Island economies do not have separate currencies; they use
either US, Australian or New Zealand dollars. Thus, they cannot have the exchange rate
instrument as suggested by the Corden model, but they can still use wages policy for
employment target. Second, even for those economies which have their own currencies,
the assumption of perfect capital mobility is not relevant, as this would require perfect
substitutability between domestic and foreign bonds. However, even when the
assumption of perfect capital mobility is replaced with incomplete capital mobility,
Treadgold shows that under different labour market conditions, the policy implications
of the basic Corden model remain relevant. When money wages are inflexible
downward, the achievement of the employment target would require abandoning an
independent inflation target. That is, the exchange rate should be varied to achieve the
domestic inflation needed to reduce real wage for the employment target. On the other
hand, the downward real wage inflexibility excludes the possibility of achieving any
independent employment target, and macro policy (i.e., exchange rate policy) should be
directed to controlling the price level only. Finally, the microstates which experience a
high degree of labour mobility with larger economies essentially face a given real wage
determined in the larger economies. Their labour market mimics a competitive labour
market, and hence, employment is determined endogenously. As in the case of
downward real wage inflexibility, these microstates should use the exchange rate to
achieve the inflation target.
In sum, fiscal and monetary policies cannot play stabilizing roles in any of the three
theoretical models reviewed above. In the Corden model and its modified version, the
stabilization (price level and employment) role is assigned to the exchange rate and
wages policies. The fact that some Caribbean and Pacific Island economies could
successfully maintain very low inflation rates by using conventional demand
management policies proves Khatkhate and Short’s conclusion wrong. To the extent
that the effectiveness of policy instruments (exchange rates) in the Corden-Treadgold
framework depends on falling real wages, it does not offer much hope in economies
where poverty is high and real wage is at the subsistence level. In these countries, real
wage resistance does not have to be an outcome of a centralized wage-setting
mechanism and/or the nature labour market institutions. Real wage is already so low
that it cannot be reduced any further.
18
All three models focus on the demand-side role of fiscal and monetary policies and
ignore the fact that in developing countries, these policies are used predominantly for
economic growth and hence enhancing aggregate supply. Thus, employment creations
in these models imply movement along the labour demand curve (i.e., the reduction in
real wage). They also assume symmetry in both capital inflows and outflows, and
consider only short-term portfolio investment, not long-term foreign direct investment.
Most developing countries, especially the small Caribbean and Pacific Island
economies, do not attract much capital flows. As noted earlier, vulnerability risks
outweigh the expected gains from interest rate differentials, and they are more prone to
capital flights than capital inflows. For their long-term economic growth, they need
foreign direct investment and foreign aid, which are not sensitive to interest rate
differentials. Once these considerations are taken into account, fiscal and monetary
18
Lodewijks (1988) deals exhaustively with the limitations of real wage cuts in the context of PNG.