RDP 9006: Wage Contracts, Sticky Prices and Exchange Rate Volatility: Evidence from Nine Industrial Countries 1. Introduction

This paper examines the relationship between real and nominal wage flexibility, the stickiness of goods' prices, and the volatility of nominal exchange rates. The motivation for this study is to find a link between two of the most striking global macroeconomic developments since the early 1970's – the secular rise in unemployment rates^[1] and the apparently inexplicable volatility of real exchange rates.^[2]

These phenomena can both be viewed as prima facie empirical falsifications of the notion that the world consists of continuously clearing competitive markets. However, an important distinction needs to be made between these two events. The increase in unemployment has been attributed largely to a real rigidity, namely, the inability of real wages to adjust in the face of adverse shocks, such as an oil shock. On the other hand, the volatility in real exchange rates i.e. the failure of purchasing power parity (PPP) to hold, has been attributed primarily to the stickiness of goods' prices, which is a nominal rigidity.

In this paper I construct a model of overlapping wage contracts and nominal price determination which examines the effects on aggregate supply of the nominal and real rigidities discussed above. The model permits a test of two related hypotheses. The first is that an excessive degree of wage indexation in the major industrial countries resulted in real wages being set above the levels that would have cleared the labour market in the period 1973–1988. The second is that the greater is the degree of nominal wage and price rigidities, the greater will be the variance of nominal exchange rate innovations and hence in the short term, real exchange rate innovations. The countries examined are Australia, Austria, Canada, France, Germany, Italy, Japan, the United Kingdom and the United States.

The model is outlined in Section 2; optimal wage contracts are derived in Section 3 with empirical questions addressed in Sections 4 and 5. Section 6 contains a summary and conclusions.

Anticipating the conclusions, I find support for the real wage rigidity hypothesis for only two countries, Germany and the United Kingdom. However, I find compelling evidence that nominal wage and price rigidities are a cause of volatile real exchange rates for all the countries examined. In those countries where it exists, the requisite flexibility of real product wages in the face of sticky nominal wages and prices is brought about through the dynamics of prices, wages and exchange rates, and the indexation of wages to consumer prices.

Footnotes

Bruno and Sachs (1986) provide an extensive analysis of unemployment in the major industrial countries over this period. For a recent analysis of European unemployment, see Dreze and Bean (1990). [1]

Inexplicable that is, in terms of an equilibrium response to changes in fundamental economic conditions (Mussa, 1986). Branson (1986) considers the large real appreciation of the $US in the early 1980's to have been an equilibrium response to a permanently more expansionary fiscal policy. However, many puzzles remain e.g. Germany and Japan have had stable policies but the DEM/Yen real exchange rate has nevertheless been very volatile. [2]