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France: Selected Issues

Author(s):
International Monetary Fund
Published Date:
November 2005
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II. Estimating the Macroeconomic Effects of Higher Competition in Labor and Product Markets16

A. Introduction

28. Greater competition would reduce markups in goods and labor markets, lower prices, and increase output and employment. The Fund’s global economic model (GEM) is used here to quantify the macroeconomic effects of increasing competition in France and the euro area. Simulations of the effects of lowering markups in product and labor markets show large gains in GDP, employment, and consumption, once the adjustment is completed. The dynamic adjustment paths following reforms in labor, services (nontradables), and goods (tradables) markets illustrate the advantages of exploiting reform complementarities across markets and the gains of coordinating structural reform among euro area countries.

29. GEM is a useful tool to analyze macroeconomic effects and cross-country implications of structural reform. GEM is a large-scale version of new open economy macro models and thus incorporates international economic linkages. Its structural equations are rooted in microeconomic theory, making GEM less susceptible to the Lucas critique, an advantage over traditional macro models. While the latter can provide valuable insights into the past and have been useful for short-term forecasting, they might be misleading when economic structures change. Exactly this happens when markets become deregulated and more open to domestic and foreign competition. Within its choice-theoretic framework, GEM assumes monopolistic competition, which allows the explicit analysis of removing distortions. At the same time, the judicious use of adjustment costs for nominal and real variables enables GEM to mimic the typical hump-shape reaction of GDP to shocks found in VAR studies.

30. The remainder of this chapter is structured as follows: Section B describes the model setup and calibration of some crucial economic relations and parameters. In Section C, the level of competition in labor and product markets in France and the other EU countries is discussed, including the size of markups. Section D looks into the economic impact of increasing competition in each market separately and the advantages of coordinating reforms within the euro area. Section E explores some fiscal policy implications. Section F concludes.

B. Model Setup and Calibration

31. In the version of GEM used here, the world consists of four blocks that have been calibrated to represent France, the euro area, and old and new non-euro area EU member states. This setting captures the EU context of structural reform in France. At various EU councils, most prominently at the Lisbon Council, the governments of the European Community have committed themselves to an ambitious reform agenda. While structural reform policies remain national, their benefits are likely to be enhanced by moving together toward best practice. Moreover, the monetary union (EMU) has increased the urgency of structural reform in the participating states.

32. GEM needs to be calibrated to represent country-specific economic relations. Country-specific parameters are derived from the national accounts and trade statistics, and behavioral parameters were taken from the relevant literature, some of which are invariant across countries, and others have been modified when country-specific information has suggested it.17Figure 1 shows country sizes by population and real GDP (in purchasing power parities) and bilateral trade flows in percent of GDP. The population and GDP shares add up to “world” population and income and are normalized at one. Trade covers intra-EU flows only. The four blocks appear therefore less open than they are in reality, and the spillover effects are limited to those that benefit EU members.18 Overall trade shares cover goods and services, while the bilateral and sector decomposition is based on trade in goods only.19 It is assumed that bilateral services trade flows are proportional to trade in goods. For France, this assumption appears to be relatively innocuous, in contrast to the United Kingdom, where the relative importance of financial services is much higher and the geographical distribution of financial services trade probably differs from trade in goods.

Figure 1.Country Size and Trade Relations

Sources: Eurostat, ECB, COMTRADE

33. The public sector is larger in France than in the other country blocks. It absorbs about 26.2 percent of GDP in France, compared to 21½ percent in the rest of the EU.20 The cross-country difference is due to public consumption, and, more importantly, to the public sector wage bill, which is higher in France (13.9 percent of GDP) than in the other three blocks (about 11 percent), while public investment in France (2.75 percent of GDP) is only marginally higher than in the rest of the EU. Consequently, the share of nontradables in GDP is larger and the role of competitive markets more limited.

34. Nominal and real rigidities in GEM produce realistic dynamic adjustment patterns. The EU economies are characterized by relatively strong real rigidities, relatively high adjustment cost in the investment equations, and strong habit persistence in consumption, combined with a high intertemporal elasticity of substitution. There is also habit persistence in labor supply. These real rigidities are necessary to enable GEM to mimic the typical hump shape response of GDP to some standard shocks (i.e., a temporary one percentage point exogenous hike in nominal interest rates) found in VAR studies. Once the degree of real rigidities has been set, adjustment costs in price and wage equations are calibrated to reproduce realistic sacrifice ratios (2.2 in France, 2.1 in the euro area, 1.4 in Denmark, Sweden, and the United Kingdom (the RE block), and 1.6 in the New Member States (NMS)).21

35. Macroeconomic benefits of reform are sensitive to the value of two parameters. Following Bayoumi and others (2004), the elasticity of labor supply with respect to real wages was set at 0.33, the high end of estimates in micro studies. The response of output and employment to a reduction in wage markups depends positively on this elasticity. And spillover effects of reforms in one country to the rest of the EU are inversely related to the degrees of import substitution, because of the resulting stronger real exchange rate movements.22 The elasticity of substitution between imports and domestic production was set at 1.2, above econometric estimates on aggregate data, though not by much (Table 1).

Table 1.Selected Calibration Parameters
FranceEuro AreaRENMS
Elasticities of substitution
Intertemporal consumption0.9960.9960.9960.996
Elasticity of labor supply (Frisch)0.330.330.330.33
Tradable and nontradable0.500.500.500.50
Domestically-produced and imported tradables1.201.201.201.20
Habit persistence
Consumption0.910.910.910.91
Labor0.800.800.800.80
Discount factor99.499.499.499.4
Home bias
Consumption0.680.650.620.70
Investment0.280.260.240.30
Liquidity-constrained consumers (share)0.450.400.250.55
Tax rate on labor (baseline steady state)0.4570.3660.3250.410

36. GEM permits meaningful fiscal policy scenarios through the introduction of household liquidity constraints, distortionary taxes, and a fiscal rule. The share of liquidity-constraint households is assumed to be 45 percent for France.23 The fiscal policy rule ensures that the public debt-to-GDP ratio is nonexplosive in the long run, by adjusting tax rates on labor automatically so that public debt approaches a target level.24 In the baseline, the debt-to-GDP ratio gradually declines from its current level of about 65 percent to a steady state level of 51 percent of GDP in France, consistent with the “reform and upfront fiscal adjustment” scenario in the main staff report.

37. Monetary policy is set by the ECB, which targets euro area-wide indicators. Nominal interest rates (i) in France are determined by the ECB, which was assumed to follow a forward-looking rule, targeting inflation (π) in the entire euro area. Following Orphanides (2003),25 the interest rate rule nests a variety of policy strategies. France’s inflation and its output gap (gap) enter the ECB rule with the weight of its GDP in the euro area. With the euro as its currency, fluctuations in France’s nominal effective exchange rate are limited. Consequently, changes in relative prices between tradables and nontradables, or the real effective exchange rate, take the form of inflation differentials and result in important cross-country variations in the real interest rate after shocks.

C. Markups in Product and Labor Markets

Product markets

38. Markups are summary measures of firms’ pricing power in goods markets. In GEM, markups derive from the assumption that each product is made by one monopolistic firm. However, there is a very large number of firms offering (a continuum of) diverse products and services that are imperfect substitutes. Each firm sets a price for its product, given a demand curve, so as to maximize profits.26

39. The markup on prices over marginal costs (MC) is inversely related to substitution elasticities. The elasticity of substitution (θ) between products of different firms (the slope of the demand curve) determines the market power of each firm, which sets prices subject to the risk of losing marking shares. The simplicity of this relation makes the analysis tractable, but admittedly comes at the expense of being agnostic about specific reasons for imperfect competition.

40. Restrictive product market regulation curtails competition in France. Deregulation in goods markets, partly driven by EU directives, has increased competition, though product markets remain regulated. An OECD measure of the degree of product market restrictedness (PMR) lists France among the more regulated countries (OECD, 2005). Competition suffers from barriers to entry and entrepreneurship, as well as state influence in the economy.27 While most euro area member states are in a middle position, the United Kingdom takes the position of the most liberal country. The larger EU NMS are considered among the least competitive. The relative position of countries on the PMR scale was used to guide the calibration of markups in the NMS, where direct measures were not available (Figure 2).

Figure 2.Product Market Regulation Index

Source: OECD, 2005.

41. Empirical estimates show significant average markups in goods and services markets in France. For the simulations here, the assumptions about goods (tradables) and services (nontradables) markups follow largely empirical estimates by Oliveira Martins, Scarpetta, and Pilat (1996) and a number of follow-up publications (Table 2). Markups were adjusted for the size of public sectors as suggested in Bayoumi and others (2004). While these estimates are somewhat dated, Saint-Paul (2004) found that the level of markups in general may have changed little during the 1990s. Assumptions for the NMS are based on their PMR ranking. The values for the euro area are similar to those in earlier studies.28

Table 2.Markups in Product Markets
GoodsServices
France1.211.40
Euro area, excluding France1.211.40
Denmark, Sweden, and the United Kingdom1.151.27
New EU member states1.291.45

Labor markets

42. Economic rents in goods and service markets may be shared between producers and workers. Blanchard and Giavazzi (2003) made an important theoretical contribution on the macroeconomic effects of regulation in goods and labor markets. In their model, the share of rents going to workers depends on their bargaining power with firms.29 There is also abundant empirical evidence of a positive relation between goods market rents and wage premia over market clearing wages.30 Workers’ rents can assume various forms: wage premia, higher nonwage benefits, and more favorable general work conditions. All of them raise the cost of labor per unit of output. Workers’ bargaining power depends on labor market institutions, such as legal job protection, union strength, the generosity of unemployment assistance, minimum wages, the size of the public sector, and political support.

43. In GEM, workers’ bargaining power is reflected in the markup of real consumption wages over the marginal rate of substitution between consumption and leisure. Each worker offers a specific kind of labor services that is an imperfect substitute for services offered by other workers. The lower the degree of substitutability, because of skill differences, anti-competitive regulation or other factors, the higher will be the markup and the lower employment in terms of hours. The assumptions about markups in labor markets are based on Jean and Nicoletti (2002) for France, the euro area and the RE block, with some adjustment for the degree of public ownership (Table 3). Lacking empirical estimates on the NMS, it was assumed that wage markups lie in the middle between the euro area and the RE block.

Table 3.Markups in Labor Markets
Economy-wide
France1.32
Euro area, excluding France1.30
Denmark, Sweden, and the United Kingdom1.17
New EU member states1.23

D. Impact of Reform

44. Reforms are implemented through a reduction in markups in labor and product markets in France and the euro area. In each simulation, markups are gradually reduced to the level in the RE block. More specifically, markups in labor and goods markets are reduced over a period of five years, while in the services sector, where deregulation progresses slower, the lower level of markups will be reached after ten years. It is interesting to look at the relative contribution of reform in each market and subsequently at the difference between comprehensive reforms implemented only in France versus coordinated reforms across all 12 euro area countries.

a) The Contribution of More Competition in Labor and Product Markets

Long-run effects

45. The estimated overall gains from more competition are substantial in terms of GDP, employment, consumption, and welfare. Once the adjustment to reform in all markets is complete, real GDP will be about 10.7 percent above the baseline, produced by a larger capital stock (15.6 percent) and more hours worked (11.3 percent). The 8.1 percent increase in consumption is smaller than the GDP gains, because resources need to be diverted to investment, and other EU countries benefit from a transfer of purchasing power. The French real effective exchange rate depreciates by 11.3 percent, needed to boost exports given increased production capacities. The welfare gains are also sizable at 2.6 percent, weighting the benefits of higher consumption in utility terms against the disutility of working more hours (Table 4).

Table 4.Long-Run Effects of Reducing Markups in Labor and Product Markets in France 1/(Deviations from baseline in percent)
Real GDPConsumptionHours WorkedWelfare
Labor market3.73.64.70.7
Services5.83.85.01.9
Goods1.20.81.50.4
All markets simultaneously10.78.111.32.6

46. In the long run, increasing competition in each sector separately yields significant, though varying, gains in GDP and employment. Comparing the effects of reforms across markets is not straightforward. The impact depends on the size of the reform (the distance from best practice in the EU) as well as the elasticity of output and employment on changes in relative prices. Further, the relationship between the elasticity of substitution across different products and labor inputs and respective markups is nonlinear. Structural reforms produce larger reductions in markups, relative to the reform effort, the further away the starting point is from perfect competition.

47. There are important complementarities between labor and goods market reform. When implemented in isolation, labor market reform would yield a 3.7 percent increase in GDP above baseline, goods market reform 1.2 percent, and liberalization of services 5.8 percent, once adjustment is completed. Labor market reform in itself raises output, employment, and consumption, but the welfare implications are small, as the utility of higher consumption is tempered by the disutility of working more. Moreover, real wages remain permanently below baseline because goods and services prices do not decline in proportion with wages, as firms increase rents and limit the expansion of output. In combination with product market reforms, however, real wages increase as labor becomes scarce. Welfare gains are easier to achieve in services markets, where markups fall deeper, as this sector is the least competitive in the French economy (Figure 3).

Figure 3.France: Dynamic Adjustment to Labor and Product Markets Reform in France

(Deviations from baseline in percent; quarterly figures) (dotted line = labor market; dashed line = tradables; solid line = nontradables)

Dynamic adjustment paths

48. The dynamic adjustment paths of real variables in response to reforms in the three markets differ significantly. While output and employment increase quickly toward their new equilibrium levels in reaction to goods market reform, the initial effect of higher competition in services is negative and insignificant in the case of labor market reform. The differences in adjustment patterns are most evident for consumption, which exceeds its baseline values immediately after goods market reforms, but remains below baseline for about four years after services and labor market reforms. Investment becomes positive quickly after goods and services markets reforms, but reacts very slowly when higher competition in labor markets reduces markups on wages. The increase in investment is moderate because the relative price of labor to capital falls, which in turn slows down the pace of capital accumulation. In all cases, investment overshoots its long-term steady state level, which is reached once the capital stock needed to produce the higher output has been installed.

49. In the short run, the adjustment to changes in relative prices is modified by disinflation. In the first few years, domestic inflation falls as firms’ margins are squeezed, and potential output increases ahead of demand, opening up a negative output gap.31 With nominal interest rates determined euro area-wide, the real interest rate rises when inflation falls below baseline. Higher real interest rates motivate forward-looking consumers to postpone consumption in favor of investment. With domestic inflation falling below inflation rates in trade partner countries, the real exchange rate depreciates (nontradables become cheaper relative to tradables), and net exports rise. However, the improvement in the trade balance is insufficient to fully compensate for the shortfall of domestic demand relative to supply. Once the price level adjustment is completed, inflation and the real interest rate return to baseline (the neutral real rate), consumption starts rising above baseline, and investment accelerates, temporarily reducing the trade surplus.

b) The Advantages of Coordinated Reform in the Euro Area

Long-run impact

50. France would benefit from coordination within the euro area. In France, long-run GDP gains increase to 14.1 percent when both France and the euro area reduce markups in labor and product markets simultaneously. Practically all additional GDP gains are direct spillovers from reforms abroad. Stand-alone reforms in the euro area (excluding France) of equal size would raise output and lower prices there. France would profit from higher demand for its products and higher real income, a terms-of-trade effect. As a result, French real GDP would increase by 3.0 percent.32 While the long-run increase in French GDP as a result of coordinated reforms does not go beyond the combined long-run impact of reforms in each country separately, welfare gains from coordination are important. The percentage increase in consumption over baseline in France is up from 8.1 percent to 11.5 percent with relatively little additional work effort, plus 0.9 percent (Table 5).33 Consequently, welfare gains at home are bigger. Consumption is higher as the real effective depreciation is only 3.2 percent in the coordinated reform scenario, instead of 11.2 percent in the case of standalone reform in France.

Table 5.Coordinated Euro Area-wide Structural Reform—Long-run Impact on France 1/(Deviations from baseline in percent)
Real GDPConsumptionHours WorkedWelfare
Labor market4.84.75.11.5
Services6.54.55.22.5
Goods2.52.12.01.2
All markets14.111.512.24.8
Of which: spillover from Euro area3.03.20.92.1

Dynamic adjustment path

51. The adjustment in demand, wages, and prices is sluggish due to nominal and real rigidities. When markups are reduced, hours worked and the capital stock will be higher in the long run, and potential output increases. In the presence of adjustment costs in investment, habit persistence in consumption, and nominal rigidities in wages and prices, the reaction of demand is delayed. Consequently, a negative output gap appears and is closed only gradually. The fall in markups causes wages (an important nontradables input) and services (nontradables) prices to fall relatively to third countries, implying a real exchange rate depreciation, either through a nominal exchange rate depreciation or temporary deflation.34

52. While monetary policy is neutral in the long run, the adjustment path depends strongly on the stance of monetary policy during the transition. When markups are reduced only in France, area-wide nominal interest rates fall to the extent necessary to keep area-wide inflation at target, as the monetary policy rule is formulated in terms of euro area-wide indicators. The euro depreciates very little in nominal terms, as the share of France in euro area exports to EU countries outside the euro area is small. As a result, though the stance of monetary policy is optimal from a euro area-wide perspective, monetary conditions in France tighten, which exerts additional deflationary pressure in France. While the depreciation of the French real effective exchange rate is needed to balance supply and demand, it must come about through temporary lower inflation at home, further depressing prices, and raising the real interest rate. In the presence of nominal rigidities, insufficient monetary accommodation slows down the response of investment and consumption. The improvement in the trade balance does not fully compensate the initial fall in consumption, causing output and employment to drop below baseline in the first year and the output gap to be more persistent (Figure 4). The transitory adjustment problems peak after about six quarters and persist until the real interest rate returns to baseline after about five years.

Figure 4.France: Comparing Dynamic Adjustment of Stand-alone Versus Coordinated Reform

(Deviations from baseline in percent; quarterly figures) (dashed line = euro area-wide reform; solid line = stand-alone reform in France) (dashed line = euro area-wide reform; solid line = stand-alone reform in France)

53. Coordination results in faster adjustment and lower transitional costs. When markups are reduced in the entire euro area, nominal interest rates fall sufficiently to prevent transitory deflation. Real interest rates decline by 2.3 percentage points in the first year, and the nominal exchange rate depreciates by 2.9 percent. The difference this makes to demand is large during the first five years: in the case of coordinated reform, investment increases by 5.7 percent and consumption by 4.9 percent, compared to 1.7 percent for investment and -2.6 percent for consumption in the case of isolated reform in France (Tables 1 and 2 in the Annex).

E. Fiscal Policy Implications

54. Fiscal adjustment would be greatly facilitated by increasing competition in labor and product markets. In the long run, higher tax revenues from a much larger tax base let the general government debt-to-GDP ratio fall by 14 percentage points of GDP, while allowing cuts in labor tax rates by 4 percentage points. Lower labor taxes reinforce the impact of lower markups in both product and labor markets on the cost of labor. However, in the case of isolated reform in France, tax rates on labor rise initially as the gap between the actual and target debt ratios widens. The temporary hike in the labor tax rate reduces current disposable income and consumption by liquidity-constrained households (Figure 5).

Figure 5.France: Dynamics of Fiscal Variables—Stand-alone Versus Coordinated Reform

(Deviations from baseline in percentage points; quarterly data) (dashed line = euro area-wide reform; solid line = stand-alone reform in France) (dashed line = euro area-wide reform; solid line = stand-alone reform in France)

F. Conclusions

55. The simulated long-run effects of comprehensive reforms in labor and product markets are large. Once adjustment is completed, the level of GDP would be higher by 10.7 to 14.1 percent, depending on whether reforms are implemented in France only or in coordination with the other euro area countries. Hours worked would increase by 11.3 percent (stand-alone reforms) to 12.2 percent (euro area-wide coordination).

  • The long-run output gains of increasing competition are significant, but the benefits are more evenly distributed when market forces are strengthened in all markets simultaneously. While labor market reform on its own increases employment, welfare effects are higher when supplemented by product market reform.

  • With higher output and employment, fiscal adjustment is greatly facilitated. More competition leads to more capital and hours worked, thus the tax base increases.

  • There are long-run gains from international coordination of reforms due to spillover effects.

  • Coordination within the euro area would reduce the transition cost of reforms. When reforms are implemented in one euro area country only, real interest rates in the reforming country rise, causing higher upfront costs and longer transition. Synchronized euro area-wide deregulation would bring about more supportive monetary conditions.35

These results need to be interpreted carefully, apart from their sensitivity to some parameters,36 it was assumed that announced reforms are fully credible and that all actors have perfect foresight and complete knowledge of the structure of the economy. Therefore, the effects of greater competition are fully anticipated. In reality, reforms might not be credible initially, and there is uncertainty about how the economy will react.37

ANNEX
Table 1.Increasing Competition in Labor and Product Markets in France(Deviation from baseline in percent)
Average of:First YearFive YearsTen YearsLong Run
Impact in France
Real GDP-0.862.155.2110.70
Consumption-2.57-2.590.168.10
Investment1.729.6816.4817.80
Capital stock0.031.385.0015.60
Hours worked-0.963.646.7611.32
Real wage0.493.615.087.89
Welfare-11.69-2.48-1.132.64
Nominal interest rate 1/-0.16-0.050.020.00
Real interest rate 1/1.411.530.960.00
Real effective exchange rate1.125.037.0011.20
Trade balance 1/0.440.490.090.00
Spillover to euro area, excluding France
Real GDP0.250.370.480.93
Consumption0.300.420.401.00
Hours worked0.180.270.270.29
Welfare0.920.330.290.67
Nominal interest rate 1/-0.16-0.050.020.00
Real interest rate 1/-0.16-0.08-0.030.00
Real effective exchange rate0.69-1.53-2.51-4.21
Trade balance0.01-0.040.020.00
Spillover to Denmark, Sweden, and the United Kingdom
Real GDP0.090.170.200.46
Consumption0.150.190.110.49
Hours worked0.090.090.090.14
Welfare0.460.130.070.32
Nominal interest rate 1/-0.09-0.050.020.00
Real interest rate 1/-0.07-0.06-0.020.00
Real effective exchange rate-0.11-0.73-0.97-1.54
Trade balance-0.04-0.040.030.00
Spillover to New Member States
Real GDP-0.440.470.600.51
Consumption0.821.391.160.54
Hours worked0.340.200.280.16
Welfare2.911.450.980.36
Nominal interest rate 1/-0.26-0.40-0.230.00
Real interest rate 1/-0.02-0.20-0.080.00
Real effective exchange rate-4.32-2.28-1.69-1.18
Trade balance-1.00-0.64-0.400.00
Table 2.Increasing Competition in Labor and Product Markets in France and the Euro Area(Deviation from baseline in percent)
Average of:First YearFive YearsTen YearsLong Run
Impact in France
Real GDP4.468.429.6514.11
Consumption4.856.375.5111.52
Investment5.7118.2922.5820.64
Capital stock0.193.488.4219.10
Hours worked5.8710.4610.2712.21
Welfare12.712.902.034.81
Nominal interest rate 1/-2.41-0.310.170.00
Real interest rate 1/-2.34-0.61-0.010.00
Real effective exchange rate2.811.531.813.24
Trade balance0.09-0.29-0.170.00
Impact in the euro area
Real GDP3.546.578.0712.34
Consumption2.313.494.0210.13
Investment4.5615.4420.0719.00
Capital stock0.142.787.0617.40
Hours worked4.238.738.9610.78
Welfare5.150.841.174.02
Nominal interest rate 1/-2.41-0.310.170.00
Real interest rate 1/-2.31-0.49-0.110.00
Real effective exchange rate8.625.635.235.28
Trade balance0.900.400.180.00
Spillover to Denmark, Sweden, and the United Kingdom
Real GDP0.431.191.382.58
Consumption0.770.860.912.74
Hours worked0.990.800.570.79
Nominal interest rate 1/-0.160.130.240.00
Real interest rate 1/-0.22-0.12-0.020.00
Real effective exchange rate-4.32-5.60-6.95-9.13
Trade balance-0.170.220.210.00
Spillover to New Member States
Real GDP-1.882.532.973.40
Consumption4.586.324.883.66
Hours worked0.830.461.291.08
Nominal interest rate 1/-2.40-2.28-1.000.00
Real interest rate 1/-1.20-1.33-0.500.00
Real effective exchange rate-24.15-11.68-8.77-7.81
Trade balance-5.10-2.63-1.390.00
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Prepared by Werner Schule.

See Bayoumi and others (2004) for the calibration details. This paper follows in their footsteps.

Bayoumi and others (2004) estimate spillovers from the euro area to the rest of the world, which provide a benchmark for the degree of underestimation of spillover effects due to the reduced-openness assumption.

Trade flows are based on the UN COMTRADE statistics. For the sake of simplicity, the commodities sector was excluded from this version of GEM.

The resource allocation to the public sector is based on national accounts data (WEO database). They do not include income redistribution.

Estimates of sacrifice ratios, the cumulated output costs of reducing inflation permanently by 1 percentage point, are often higher than these values, but they might reflect slow learning by central banks during the transition from a high to a low inflation environment.

For an extensive discussion of the sensitivity of results with respect to these parameters see Bayoumi and others (2004).

Empirical estimates of the share of liquidity-constraint households in France based on macro data are very large (up to 100 percent). However, these estimates are likely biased on the high side, because they refer to the pre financial liberalization period in France and the euro area and use highly aggregated macro data. Household surveys and credit data would indicate smaller shares.

Tax rates on capital income are fixed at 10 percent. More sophisticated scenarios can be run by changing expenditures and taxes discretionary, alleviating the burden that falls on labor taxation.

See also WEO April 2005, Annex 3.3 to Chapter III.

This simple formula ignores adjustment costs. An elasticity of substitution of 5 translates into a markup of 1.25 (25 percent). The markup goes to zero only if all products are perfect substitutes.

More precisely, the OECD measure covers trade and investment restriction, regulatory barriers, discriminatory procedures, or ownership barriers; licensing and permits, administrative, sector-specific, and legal burdens, anti-trust exemptions; and state influence measured by the size and scope of the public enterprise sector, direct controls over business, and price controls or restrictions on establishment. See Conway and others (2005).

Gali, Gertler, and Lopez-Salido (2002) developed a related model that explains the bulk of output gap fluctuations with price and wage markups.

Including recent work by: Jean and Nicoletti (2002), Saint-Paul (2004);Crepon, Desplatz, and Mairesse (2002); Dobbelaere (2005);Konings, Van Cayseele, and Warzynski (2001). Interestingly, Dobbelaere found much higher estimates of product market markups when estimated jointly with labor market equations measuring the bargaining power of workers.

Demand reacts sluggishly because of real and nominal rigidities in the model while the gradual implementation of reforms makes sure that potential output does not jump; this time pattern is entirely plausible for France and the EU as a whole.

Results are not reported here but are available on request.

The flipside of the coin: for a given increase in output, employment increases by less.

More competition in the tradables sector lowers tradables prices vis-à-vis nontradables prices and therefore represents a real appreciation of the home currency.

Raising competition represents an asymmetric positive supply shock when implemented in one country only.

Work is currently under way in the IMF’s Research Department to estimate some of the parameters of a scaled-down version of GEM using Bayesian techniques.

Vagaries typically lead to caution, including on the side of monetary policymakers. As a result, monetary conditions might not be sufficiently accommodative, even in the case of synchronized euro area-wide reform.

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