The Exchange Rate as an Intermediate Target of Stabilization Policy in Austria

Abstract

After the breakdown of the Bretton Woods system, Austria adhered to an exchange rate policy of adjustably pegging the schilling to a basket of stable currencies. Over the years the basket changed according to the respective priorities of overall economic policy and eventually shrunk to a single hard currency, the deutschmark. The resulting effective appreciation of the schilling was intended to import price stability. In the second half of the 1970s, that policy became inconsistent when monetary and fiscal policies were eased to counter the consequences for growth and employment of the spreading international recession. As a consequence the deficit on current account increased rapidly and eventually, by mid 1977, resulted in a de facto tightening of monetary policy and a (slight) depreciation of the schilling against the deutschmark. The official arguments in favor of maintaining the hard currency policy can be traced either to the (long-run) "Scandinavian" model of inflation transmission or to the vicious circle hypothesis (a depreciation induces inflation which in turn leads to further depreciation) or to considerations of an optimum currency area comprising Germany and Austria. In the paper it is shown that (i) the Scandinavian model must be heavily adapted to deal with short-run policies, (ii) a vicious circle was unlikely to develop given the remarkable real wage flexibility in Austria, and (iii) a currency union with Germany was harmful to real sector developments in Austria. The paper concludes that Austria, given the change in policy priorities from inflation targeting to fighting unemployment, maintained the hard currency policy much too long.

Keywords: hard currency policy, vicious circle, optimum currency area, Austria, Scandinavian model

JEL Classification: E31, E42, E52, F40, N10