Dangers for Ireland of an E M U without the UK: Some Calibration Results

This paper presents a small-open-economy model calibrated to Ir ish data. The model can be used for many purposes. It is applied here to the E M U debate. It comes close to replicating the employment effects of sterling weakness (with Ireland in E M U ) reported in the recent E S R I study (Policy Research Series Paper No. 28, 1996). When the assumptions on wage flexibility are changed in an arguably more plausible direction, though, we find that the employment effects are magnified considerably. Given the narrowness of the outcome in the E S R F s judgement, our results provide support to remaining outside E M U until the U K joins. I I N T R O D U C T I O N T hree effects o f E M U ' h a v e been m u c h d iscussed i n t h e I r i s h case. These a re t h e s a v i n g s i n f o r e i g n c u r r e n c y t r a n s a c t i o n s costs , t h e a r g u a b l y b e n e f i c i a l i n t e r e s t r a t e effects o f p a r t i c i p a t i o n i n E M U , a n d t h e dange r s fo r t h e I r i s h economy o f a w e a k s t e r l i n g i f I r e l a n d j o i n s E M U a n d t h e U K does not . G i v e n t h e e x t e n t o f I r i s h t r a d e w i t h t h e U K , t h e sav ings i n t r a n s a c t i o n s costs w o u l d be s u b s t a n t i a l l y less t h a n i n t h e case w h e r e t h e U K also j o i n e d . E v e n t h e h i g h e r s av ings i n a n E M U t h a t c o m p r i s e d a l l E U c o u n t r i e s , h o w ­ ever, E i c h e n g r e e n (1993) a n d o the r s r e g a r d as r e l a t i v e l y s m a l l c o m p e n s a t i o n for t a k i n g o n t h e r i s k s associated w i t h g i v i n g u p t h e exchange r a t e . Paper presented at the Eleventh Annual Conference of the Irish Economic Association. *I am grateful to John Fitz Gerald and Anthony Murphy for helpful discussions, and to Gerry Boyle for supervising the refereeing process. T h e 1996 E S R I r e p o r t o n t h e i m p l i c a t i o n s o f E M U for I r e l a n d ( B a k e r , F i t z G e r a l d a n d H o n o h a n , 1996) concen t r a t e s o n e v a l u a t i n g t h e bene f i t s o f t h e p o s i t e d i n t e r e s t r a t e r e d u c t i o n s r e l a t i v e t o t h e costs o f p o t e n t i a l s t e r l i n g w e a k n e s s . T h e o v e r a l l conc lu s ion o f t h e r e p o r t i s t h a t t h e r e a re l i k e l y t o be n e t b e n e f i t s for I r e l a n d o f p a r t i c i p a t i o n , even i f t h e U K r e m a i n s ou t s ide . I n t h i s even t , h o w e v e r , t h e n e t benef i t s a re l i k e l y to be s m a l l . I w i l l h a v e n o t h i n g to say here o n t h e ESRFs e v a l u a t i o n o f t h e i n t e r e s t r a t e bene f i t s . I n s t e a d , I c o n c e n t r a t e so le ly o n t h e d o w n s i d e — t h e e m p l o y m e n t i m p l i c a t i o n s o f s t e r l i n g w e a k n e s s . I a r g u e t h a t t h e E S R I r e p o r t m a y h a v e s e r i o u s l y u n d e r e s t i m a t e d these adverse effects. I f t h i s i s co r rec t t h e n t h e i r o v e r a l l c o n c l u s i o n o f a n e t m a r g i n a l bene f i t for I r e l a n d o f p a r t i c i p a t i o n i n a n E M U t h a t does n o t i n c l u d e t h e U K i s l i k e l y t o be o v e r t u r n e d . M y a r g u m e n t i s based p r i m a r i l y o n t h e f a i l u r e o f t h e E S R I m o d e l t o a l l o w fo r a s y m m e t r i e s i n t h e response o f wages t o i n f l a t i o n a r y a n d d e f l a t i o n a r y shocks. N o m i n a l wages t e n d t o be r e l a t i v e l y s t i c k y i n a d o w n w a r d s d i r e c t i o n a n d m u c h m o r e f l e x i b l e i n a n u p w a r d s d i r e c t i o n , as a r g u e d r e c e n t l y b y A k e r l o f , D i c k e n s a n d P e r r y (1996) , so a n exchange r a t e a p p r e c i a t i o n ( aga in s t s t e r l i n g ) w o u l d be l i k e l y to r a i s e r e a l wages a n d gene ra t e u n e m p l o y m e n t w h i l e a n exchange r a t e d e p r e c i a t i o n w o u l d be m o r e l i k e l y to be d i s s i p a t e d i n i n f l a t i o n . 1 W h y i s t h i s n o t recognised i n t h e E S R I model? T h e p r o b l e m is t h a t t h e w a g e f o r m a t i o n process i n t h a t m o d e l i s ba sed o n e s t i m a t e s o f t h e response o f wages t o p r i ce m o v e m e n t s b e t w e e n 1983 a n d 1995. T h e r e w e r e no d r a m a t i c u n a n t i c i p a t e d p r i ce r e d u c t i o n s over t h i s pe r iod , however , s ince each s h a r p f a l l i n s t e r l i n g w a s f o l l o w e d b y a d e v a l u a t i o n o f t h e I r i s h p o u n d a g a i n s t t h e D M . I t c a n n o t be c o n c l u d e d f r o m t h i s d a t a t h e n t h a t t h e response o f wages t o u p w a r d a n d d o w n w a r d p r i ce m o v e m e n t s i s s y m m e t r i c . T h e r e f u s a l t o r e n e g o t i a t e n o m i n a l w a g e a g r e e m e n t s d o w n w a r d s w h e n s t e r l i n g f e l l s h a r p l y o n d e p a r t u r e f r o m t h e E R M suggests, to t h e c o n t r a r y , a n a s y m m e t r i c response. A second r e l e v a n t w e a k n e s s o f t h e E S R I m o d e l is t h a t i t does n o t t a k e a c c o u n t o f t h e p o t e n t i a l f o r h y s t e r e s i s i n u n e m p l o y m e n t i f t h e s t e r l i n g sens i t i ve sectors a re p e r t u r b e d . B a r r y a n d H a n n a n (1996) show t h a t w o r k e r s i n t r a d i t i o n a l i n d u s t r y a re s u b s t a n t i a l l y less s k i l l e d t h a n w o r k e r s i n t h e m o d e r n sector; T a b l e 1 b e l o w . 2 T h e y also p o i n t o u t t h a t less s k i l l e d w o r k e r s face m u c h g r e a t e r d a n g e r s o f b e c o m i n g l o n g t e r m u n e m p l o y e d . T h e i m p o r t a n c e o f t h i s fo r t h e p r e s e n t a r g u m e n t i s t h a t i t i s c lea r f r o m B a k e r 1. This is of course the basis of the convexity of the Phillips Curve. 2. In line with most international studies, the category "Administrative and Technical Staff" in the Census of Industrial Production is associated with skilled workers, and "Industrial Workers" with unskilled workers. While the categorisation is tenuous, it is the closest approx­ imation available in the data. (1993) a n d B a r t o l i n i (1993) , t a k e n i n c o n j u n c t i o n , t h a t t r a d i t i o n a l i n d u s t r y is a lso m o r e s t e r l i n g s e n s i t i v e . A p e r i o d o f d e c l i n e i n t h e s t e r l i n g s e n s i t i v e sectors i s t he re fo re m o r e l i k e l y to genera te hys te res i s i n u n e m p l o y m e n t t h a n i s a m o r e b road ly -based recession. T a b l e 1: Skilled Employment as a Percentage of Total Employment Skilled Relative to Total Employment (%) 1979 1990 Manufacturing of which: 10.3 12.8 Traditional 9.9 11 Modern 3 13 17.9 Market Services 11.8 15.9 Building/Construction 5.2 6.7 Note: The Services and Building and Construction data refer to the years 1981 and 1991. T h e r e m a i n d e r o f t h e p a p e r i s s t r u c t u r e d as f o l l o w s . T h e n e x t s e c t i o n p r e s e n t s a b r i e f o v e r v i e w o f r e l e v a n t t h e o r y . T h e E S R I r e s u l t s a r e t h e n p re sen ted . Sec t ion I V develops a basic smal l -open-economy ( S O E ) m o d e l t h a t w e c a l i b r a t e t o I r i s h da t a . I t d e m o n s t r a t e s h o w successfu l ly t h e m o d e l c a n r e p l i c a t e t h e E S R I r e s u l t s o f i n t e r e s t , a n d t h e i m p l i c a t i o n s o f v a r i o u s a l t e r n a t i v e scenarios can t h e n be exp lored . I I T H E M A C R O E C O N O M I C S O F E X C H A N G E R A T E S H O C K S E x c h a n g e r a t e changes are t y p i c a l l y t h o u g h t o f as nominal shocks. In the absence of nominal rigidities ( s u c h as m o n e y w a g e s t i c k i n e s s ) such shocks should have no real effects (e.g., o n e m p l o y m e n t o r r e a l o u t p u t ) , because a l l n o m i n a l v a r i a b l e s w i l l change e q u i p r o p o r t i o n a t e l y . R e l a t i v e p r ices ( w h i c h i n t h e absence o f n o m i n a l r i g i d i t i e s d e t e r m i n e t h e v a l u e s o f r e a l v a r i a b l e s ) t h e r e f o r e r e m a i n u n c h a n g e d . F o r e x a m p l e , u n d e r r e a l w a g e r i g i d i t y , a n exchange r a t e shock, t h r o u g h i t s effect o n t h e C P I , changes n o m i n a l w a g e demands , l e a v i n g t h e n o m i n a l wage relative to output prices unaf fec ted . If there are nominal rigidities ( such as m o n e y w a g e s t i c k i n e s s ) , o n t h e o t h e r h a n d , the exchange rate shock has real effects because r e l a t i v e pr ices are changed . A t r a d i t i o n a l w a y o f t h i n k i n g a b o u t exchange r a t e shocks i s t h a t t h e y 3. Baker (1988) definition. affect . e m p l o y m e n t i n t h e s h o r t r u n ( w h e n n o m i n a l wages are s t i c k y ) b u t t h a t t hese effects d i s a p p e a r over t i m e as r e a l wage l eve l s are r e -e s t ab l i shed ; see e.g., K o u r i (1979) a n d R i sage r ( 1 9 8 7 ) . 4 Besides t h i s d i s t i n c t i o n b e t w e e n s h o r t r u n a n d l o n g r u n effects, t h o u g h , i t i s also f r e q u e n t l y a r g u e d t h a t t h e s h o r t r u n responses t o i n f l a t i o n a r y a n d d e f l a t i o n a r y shocks are n o t s y m m e t r i c ; i .e . , t h a t n o m i n a l w a g e s a n d / o r p r i ces a re m o r e f l e x i b l e u p w a r d s t h a n d o w n ­ w a r d s . 5 W h i l e t h e r e i s some n o m i n a l wage s t i ck iness i n t h e s h o r t r u n i n t h e E S R I m o d e l , wages r e s p o n d s y m m e t r i c a l l y t o i n f l a t i o n a r y a n d d e f l a t i o n a r y shocks. T h i s i s one o f t h e k e y a s s u m p t i o n s w e change i n t h e p resen t paper . T h e r e i s one f u r t h e r d i f f e r e n c e b e t w e e n t h e E S R I m o d e l a n d t h e t r a d i t i o n a l v i e w o f t h e macroeconomics o f exchange r a t e changes. T h i s is t h a t s t e r l i n g w e a k n e s s i n t h e E S R I m o d e l i s m o d e l l e d (cor rec t ly , I be l ieve) n o t as a n o m i n a l b u t as a r e a l shock: because P u r c h a s i n g P o w e r P a r i t y need n o t h o l d i n t h e s h o r t t o m e d i u m t e r m , a s u d d e n s t e r l i n g d e p r e c i a t i o n changes t h e r e l a t i v e pr ices o f s t e r l i n g d e n o m i n a t e d a n d D M d e n o m i n a t e d goods . 6 W h e n a r e a l shock i s m e t w i t h e i t h e r n o m i n a l or r e a l wage s t i ck iness , r e a l e m p l o y m e n t a n d o u t p u t effects r e s u l t . I w i l l s how t h a t these effects a re s u b s t a n t i a l l y l a r g e r u n d e r d o w n w a r d n o m i n a l w a g e s t i ck ines s t h a n u n d e r t h e degree o f n o m i n a l wage a d j u s t m e n t a l l o w e d for i n t h e E S R I m o d e l . I l l R E S U L T S O F T H E E S R I A N A L Y S I S T h e E S R I s t u d y c a l c u l a t e s t h e effects o f a 20 pe r cen t d e p r e c i a t i o n o f s t e r l i n g u n d e r t h e a s s u m p t i o n t h a t I r e l a n d is i n E M U . T h e y find t h a t i t t akes a b o u t 4 y e a r s fo r t h e r e a l effects to d i sappear ; i .e. , for i n i t i a l compe t i t i veness l e v e l s t o be r e e s t a b l i s h e d . A b o u t h a l f o f t h e r e a l d e p r e c i a t i o n o f s t e r l i n g r e l a t i v e to t h e I r i s h c u r r e n c y ( the euro) d i sappears over t h e f i r s t 2 years ; h a l f o f t h i s i n t u r n comes a b o u t t h r o u g h a n inc rease o f 5 per cen t i n U K wages , a n d t h e o t h e r h a l f t h r o u g h a f a l l o f a r o u n d 5 pe r cent i n I r i s h wages ( B a k e r et al., 1996, p p . 101-102) . A s s u m i n g t h a t m a n y e a r s l o s t peaks i n yea r 2 a n d r e t u r n s s y m m e t r i c a l l y ove r t i m e t o zero, w h a t i s de f ined here as t h e m e d i u m t e r m e m p l o y m e n t loss f r o m t h i s r e a l a p p r e c i a t i o n o f t h e I r i s h c u r r e n c y a g a i n s t s t e r l i n g is t h e m e a n o f yea r -2 a n d year -3 j o b losses: 4. In the presence of hysteresis, of course, the short-run real effects persist into the long run; Barry (1997a). 5. One explanation for this builds on the assumption that workers are concerned with relative wages, and that wage contracts are staggered; this makes each group of workers reluctant to be the first to reduce wage demands. The New Keynesian literature (e.g., Bal l and Mankiw, 1994) provides other explanations for why nominal variables may be more flexible upwards than downwards. 6. This requires that the two types of goods should not be perfect substitutes for each other; otherwise the "law of one price" would hold at all times. Tab le 2: ESRI Estimates of Job Losses from 20 Per Cent Fall in Sterling, with 5 Per Cent Rise in UK Wages and 5 Per Cent Fall in Irish Wages Manufacturing 11,000 Building 11,000 Market Services 3,000 Source: E S R I (1996), p. 119 W e i n t e r p r e t t h i s shock as a 15 pe r cent f a l l i n s t e r l i n g ( i .e . , t h e 20 pe r cen t f a l l offset b y a n inc rease o f a r o u n d 5 p e r c e n t i n U K w a g e s a n d p r i c e s ) a longs ide a 5 pe r cen t f a l l i n I r i s h wages . I f w e c a n r e p l i c a t e these n u m b e r s w i t h o u r c a l i b r a t e d s m a l l o p e n e c o n o m y m o d e l , w e c a n t h e n e x p l o r e t h e i m p l i c a t i o n s o f c h a n g i n g t h e E S R I s tudy 's a s s u m p t i o n s o n wage f l e x i b i l i t y . I V T H E S M A L L O P E N E C O N O M Y M O D E L C A L I B R A T E D T O I R I S H D A T A 4.1 The Basic Three-Sector SOE Model W e a s s u m e t h a t t h r e e t y p e s o f goods a re p r o d u c e d i n I r e l a n d : t w o t r a d a b l e s a n d one n o n t r a d a b l e . T h e economy i s a p r i c e t a k e r i n t h e m a r k e t fo r each t r a d a b l e good, a n d t h e pr ices o f these goods o n w o r l d m a r k e t s a re i n d e p e n d e n t o f each o the r . T r a d a b l e goods a re s u b s c r i p t e d B a n d G . G o o d B compe tes w i t h B r i t i s h p r o d u c e d goods, o r w i t h o t h e r s i m i l a r goods w h o s e p r ices a re d e t e r m i n e d o n t h e B r i t i s h m a r k e t . T h e I r i s h p r i ce o f these goods i s d e t e r m i n e d b y t h e s t e r l i n g p r i ce , p B * , m u l t i p l i e d b y t h e I r i s h p o u n d p r i c e o f s t e r l i n g , e B :