This paper examines the evolution of the relative price between tradable and nontradable goods in a group of European countries. A model of an open economy is used to analyze different factors that can account for an increase in the relative price of nontradable goods.
The labor market plays a crucial role in the economy, transmitting shocks to the real wage and the real exchange rate. This paper postulates a centralized bargaining arrangement, where unions act as monopolists by setting the wage rate and employers decide the level of employment. The key element of this market is that the unions’ target real wage and target level of employment are above the labor demand schedule. The target real wage could be determined, for example, by expectations of an unsustainable real exchange rate. The model also allows for a government that finances spending on nontradable goods through lump-sum taxation and productivity growth in both sectors.
The model is applied to the data to analyze the joint behavior of the current account, the relative price of nontradable goods, average labor productivity across sectors, government spending, and the sectoral composition of aggregate output. Econometric evidence on the determinants of the real exchange rate is also provided. The findings broadly reveal that demand shifts in the private sector as well as faster productivity growth in the tradable goods sector underlay the appreciation of the real exchange rates in Europe. In addition, the slow adjustment of nontradable goods prices may have played an important role in France during the second half of the 1970s and the early 1980s, in Italy since the late 1970s, and in Spain and the United Kingdom during the second half of the 1980s, In contrast, government expenditure does not appear to have played a major role, through its impact on the demand for nontradable goods, in the evolution of the real exchange rate.