The Effects of Exchange-Rate Variability on Output and Employment

Abstract

This paper is a theoretical analysis of the effects of exchange rate variability on a firm's employment and output decisions. In section 1, two contracting models are developed and the static effects are explored. In the Gray-Fischer-Conzoneri model, only exchange rate presidation errors have effects where as in the Mussa-Taylor model anticipated exchange rate movements also have effects. In section 2, the same contracting models are used to describe the dynamic effects. The time series properties of employment and output depend upon the time series properties of the exchange rate, the cost of the adjusting factor inputs, and the form of the labor contract. Also, exchange rate volatility can be profitably exploited by an individual firm that can adjust its output to price changes each period. In section 3, the implications of risk aversion are examined. Given an increase in exchange rate variability, a risk-averse firm will reduve its scale of operations if adjustment costs prohibit its responding to realizations of the exchange rate. However, if the firm is able to adjust it labor input in response to exchange rate movements, then it may well want to increase its scale of operations Aversion to the increased risk has to be weighed against the expected profitability of being able to exploit wider fluctuations in exchange rate.