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IMF Working Paper Summaries (WP/95/1 - WP/95/61)
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Summary of WP/95/10: “Wage Contracts, Capital Mobility, and Macroeconomic Policy”

Author(s):
International Monetary Fund
Published Date:
August 1995
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Nominal wage rigidity and imperfect capital mobility are two important macroeconomic features of many developing countries. This paper integrates both features in an analysis of the effects of macroeconomic policy shocks on output, real wages, the real exchange rate, and the current account. The analysis is based on a two-sector, three-good optimizing model with endogenous mark-up pricing in the nontraded goods sector. Both backward-and forward-looking wage contracts are considered. Because of the highly complex dynamic structure of the model (which is shown to depend crucially on the nature of the expectational mechanism embedded in wage contracts), the analysis focuses on the steady-state effects of policy shocks.

The paper shows that the long-run macroeconomic effects of a reduction in spending on nontraded goods is shown to be independent of the mechanism through which contracts are formed. It lowers the marginal value of wealth (and thus stimulates private consumption), reduces the product wage (thereby raising output in the export sector), and leads to a depreciation of the real exchange rate. Real holdings of foreign bonds (measured in domestic currency terms) rise, whereas net foreign assets held by the central bank may rise or fall. A cut in public spending has no effect on either inflation and output of nontraded goods, or on nominal and real interest rates. By contrast, the steady-state effects of a reduction in the devaluation rate on several macroeconomic variables is shown to depend crucially on whether wage contracts are backward or forward looking. In the case of backward-looking contracts, the real exchange rate depreciates while the product wage rises, leading to a reduction in output in the export sector. With forward-looking contracts, the real exchange rate appreciates while the real product wage falls, leading to an expansion in output of exportables. In both cases, however, inflation, the rate of growth of nominal wages, and the nominal interest rate fall in the same proportion as the devaluation rate--with no net effect on the real interest rate.

The thrust of the analysis in the paper is that the extent to which the nature of wage contracts alters the long-run effects of macroeconomic policies--particularly on the real sector of the economy--depends on the type of shocks considered. An understanding of the mechanisms through which wage contracts are formed is thus important for the choice of policy instruments in stabilization programs.

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