Since the early 1970s, the Nordic EFTA countries have pegged their exchange rates to various trade or payments-weighted baskets of foreign currencies, in order to stabilize foreign trade and, more recently, restrain inflation. They have eschewed free floating because of the potentially destabilizing effects of exchange rate volatility on trade, investment and employment, while seeking to preserve the ultimate independence of their macroeconomic policies by not participating in the EMS or other international arrangements.
In Discussion Paper No. 377, Thorvaldur Gylfason reviews the exchange rate policies of the Nordic EFTA countries since the early 1970s and their consequences for economic performance. Compared with other developed countries, the Nordic group has experienced lower unemployment with higher inflation and larger current account deficits, without inflation or external debt getting out of hand. In view of the persistent inflation problem in these countries, Gylfason argues, fixed exchange rates have several desirable properties. They contribute to price stability, by containing import prices, enforcing strict monetary and fiscal discipline, and placing responsibility for the employment consequences of wage settlements directly with unions and employers, thereby encouraging moderate increases in line with productivity and world export prices.
Problems arise, however, when wages outpace the ability of firms to pay. Should the authorities continue to insist on maintaining the exchange rate? This is an especially difficult problem in the Nordic countries, according to Gylfason, where the organization of unions along occupational and industry lines, rather than firm by firm, means wage rises negotiated by one group of workers can threaten the jobs of other groups as well. This increases the pressure on the government to accommodate wage increases with a devaluation, and is an important factor behind the wage spiral observed in Finland and to some extent in Norway and Sweden during 1977-82 and in Iceland since at least the late 1960s.
Focusing on the experience of Finland, Norway and Sweden during 1976-82, econometric simulations confirm that each devaluation was followed by a significant medium-term current account improvement, without any substantial increase in unemployment. This suggests that trade flows responded favourably to relative price changes and that the benefits of the devaluations were not eroded by monetary accommodation or wage inflation. This is supported by econometric evidence of substantial relative price elasticities of exports and imports in all three countries and in Iceland, and by numerical simulations of simple analytical models of the macroeconomic effects of devaluation.
But the success of repeated devaluations may cause problems, Gylfason warns, signalling to employers and wage earners that excessive wage rises are unlikely to jeopardize profitability, export revenues or employment because the government will devalue again if pressed. Under these circumstances, the credibility of the commitment to a fixed exchange rate may be eroded and demands for devaluation prove increasingly difficult to resist, setting in motion an inflationary spiral.

Exchange Rate Policy, Inflation, and Unemployment: The Experience of the Nordic EFTA Countries
Thorvaldur Gylfason

Discussion Paper No. 377, February 1990 (IM)