The Australian dollar is currently appreciating strongly against many key currencies and this has put pressure on our international competitiveness. Given the terms of trade are so strong, a cut in wages and the rate of inflation would be the way to restore competitiveness. This would help maintain strong export growth.
Answer: Maybe
The answer is Maybe.
This question also applies to the EMU nations who cannot adjust their nominal exchange rate but are seeking export-led demand boosts as they cut government spending.
The temptation is to accept the dominant theme that is emerging from the public debate is telling us.
However, deflating an economy under these circumstance is only part of the story and does not guarantee that a nation's competitiveness will be increased.
We have to differentiate several concepts: (a) the nominal exchange rate; (b) domestic price levels; (c) unit labour costs; and (d) the real or effective exchange rate.
It is the last of these concepts that determines the "competitiveness" of a nation. This Bank of Japan explanation of the real effective exchange rate is informative. Their English-language services are becoming better by the year.
Nominal exchange rate (e)
The nominal exchange rate (e) is the number of units of one currency that can be purchased with one unit of another currency. There are two ways in which we can quote a bi-lateral exchange rate. Consider the relationship between the $A and the $US.
So to understand exchange rate quotations you must know which is the reference currency. In the remaining I use the first convention so e is the amount of $A which is required to buy one unit of the foreign currency.
International competitiveness
Are Australian goods and services becoming more or less competitive with respect to goods and services produced overseas? To answer the question we need to know about:
Clearly within the EMU, the nominal exchange rate is fixed between nations so the changes in competitiveness all come down to the second source and here foreign means other nations within the EMU as well as nations beyond the EMU.
There are also non-price dimensions to competitiveness, including quality and reliability of supply, which are assumed to be constant.
We can define the ratio of domestic prices (P) to the rest of the world (Pw) as Pw/P.
For a nation running a flexible exchange rate, and domestic prices of goods, say in the USA and Australia remaining unchanged, a depreciation in Australia's exchange means that our goods have become relatively cheaper than US goods. So our imports should fall and exports rise. An exchange rate appreciation has the opposite effect which is what is occurring at present.
But this option is not available to an EMU nation so the only way goods in say Greece can become cheaper relative to goods in say, Germany is for the relative price ratio (Pw/P) to change:
The inverse of the relative price ratio, namely (P/Pw) measures the ratio of export prices to import prices and is known as the terms of trade.
The real exchange rate
Movements in the nominal exchange rate and the relative price level (Pw/P) need to be combined to tell us about movements in relative competitiveness. The real exchange rate captures the overall impact of these variables and is used to measure our competitiveness in international trade.
The real exchange rate (R) is defined as:
R = (e.Pw/P) (2)
where P is the domestic price level specified in $A, and Pw is the foreign price level specified in foreign currency units, say $US.
The real exchange rate is the ratio of prices of goods abroad measured in $A (ePw) to the $A prices of goods at home (P). So the real exchange rate, R adjusts the nominal exchange rate, e for the relative price levels.
For example, assume P = $A10 and Pw = $US8, and e = 1.60. In this case R = (8×1.6)/10 = 1.28. The $US8 translates into $A12.80 and the US produced goods are more expensive than those in Australia by a ratio of 1.28, ie 28%.
A rise in the real exchange rate can occur if:
A rise in the real exchange rate should increase our exports and reduce our imports.
A fall in the real exchange rate can occur if:
A fall in the real exchange rate should reduce our exports and increase our imports.
In the case of the EMU nation we have to consider what factors will drive Pw/P up and increase the competitive of a particular nation.
If prices are set on unit labour costs, then the way to decrease the price level relative to the rest of the world is to reduce unit labour costs faster than everywhere else.
Unit labour costs are defined as cost per unit of output and are thus ratios of wage (and other costs) to output. If labour costs are dominant (we can ignore other costs for the moment) so total labour costs are the wage rate times total employment = w.L. Real output is Y.
So unit labour costs (ULC) = w.L/Y.
L/Y is the inverse of labour productivity(LP) so ULCs can be expressed as the w/(Y/L) = w/LP.
So if the rate of growth in wages is faster than labour productivity growth then ULCs rise and vice-versa. So one way of cutting ULCs is to cut wage levels which is what the austerity programs in the EMU nations (Ireland, Greece, Portugal etc) are attempting to do.
But LP is not constant. If morale falls, sabotage rises, absenteeism rises and overall investment falls in reaction to the extended period of recession and wage cuts then productivity is likely to fall as well. Thus there is no guarantee that ULCs will fall by any significant amount.
Further, the reduction in nominal wage levels threatens the contractual viability of workers (with mortgages etc). It is likely that the cuts in wages would have to be so severe that widespread mortgage defaults etc would result. The instability that this would lead to makes the final outcome uncertain.
Given all these qualifications, the answer is maybe (but undesirable).
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