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Exchange Rates, Inflation, and Vicious Circles

Author(s):
International Monetary Fund. Research Dept.
Published Date:
January 1980
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Since the advent of floating exchange rates in the early 1970s, many industrial countries have experienced episodes of accelerating price inflation and exchange rate depreciation. These experiences have led to a revival of interest in the vicious circle hypothesis, which, in its simplest form, states that, in a world of floating exchange rates, an initial disturbance (either domestic or foreign) can set in motion a cumulative process of price inflation and exchange depreciation, through which the exchange rate effect is rapidly passed through into domestic prices and costs and back again to the exchange rate. 1 The dual of the vicious circle thesis is the virtuous circle hypothesis, which is associated with exchange rate appreciation and price stability.

The purposes of this paper are to assess how and why vicious circles can occur and to consider whether certain countries are more prone to them than others. The paper provides a theoretical framework for analyzing these questions and for discussing the relevant empirical evidence.

The view adopted is that the vicious circle, in general, originates as a phase of the adjustment process following a real or monetary shock that disturbs the steady state of the system. The pattern of adjustment depends upon the nature of the inital disturbance, but, under certain circumstances, there will be a phase of the adjustment process during which the economy enters a period of rapid inflation of both wages and prices, rising unemployment, and exchange rate depreciation. In the absence of policies that will accommodate wage and price inflation (that is, monetary accommodation), this phase will be followed by a period during which price and wage inflation abates, and employment begins to increase, as the economy adjusts to its new steady state. In some countries, however, the authorities may follow a policy of accommodation during the crucial phase of adjustment in the hope of ending the period of high unemployment sooner. This action has the effects of preventing the necessary price, wage, and other adjustments from taking place; prolonging the stagflation phase; and delaying the movement of the economy toward its new steady state. If the authorities persist in implementing such a policy of accommodation, a continuous vicious circle of domestic price increases and exchange depreciations will be unavoidable. Once allowed to develop, the process will become more and more difficult to stop.

Section I expands on this theory of the origins of vicious circles. First, the adjustment process from one steady state to another in the absence of monetary accommodation is described. Second, the effect of an accommodating monetary policy on this adjustment process is examined. Section II provides the empirical evidence and focuses on identifying the features of a country that are responsible for vicious circles; the role of policy in vicious circle countries is also discussed, together with institutional and political considerations. The main conclusions of the paper are presented in Section III.

I. Analysis of the Adjustment Process

The key to understanding vicious circles may be found by determining what kind of adjustment process is set in motion following a disturbance in the absence of monetary accommodation. Once this process is defined, the reason monetary accommodation occurs and the channels through which it might change the adjustment process and push the economy into a vicious circle can be examined.

In order to describe the process of adjustment that follows a disturbance, a simple theoretical framework using small, open country assumptions and a flexible exchange rate regime is assumed. The foreign interest rate and foreign price of goods are determined exogenously for the country concerned. In view of the dynamic nature of vicious circles, all variables should be described in terms of rates of change, but for ease of exposition and analysis of the adjustment process, a steady-state growth rate of zero is assumed, so that all variables can be described in terms of their levels.

The model developed by Bilson (1979) can serve as a starting point, but it requires several extensions. 2 Bilson’s model is a two-country, two-currency, two-commodity model with a single internationally traded bond and instantaneous adjustment of portfolios to interest rate differentials. The most important extension made in this paper is that adjustment in portfolio composition is slow; this assumption provides a “capital flow function.” 3 Interest rates, at a given level of income, are determined by monetary conditions, and the exchange rate is determined by the balance of payments. A fall in domestic interest rates as a result of a monetary expansion, for example, results in the anticipation of long-run exchange depreciation, and a capital outflow ensues because portfolio substitution takes place over time in response to changes in actual or expected international yield differentials. These speculative capital outflows lead to an exchange rate depreciation (in order to achieve portfolio equilibrium at each point in time). Exchange depreciation results in an improvement in the trade balance, and the depreciation must be sufficient to ensure that capital outflows are continuously equal to the trade surplus. This slow adjustment in portfolio composition provides the link between the current account and the exchange rate. Official restrictions on foreign capital, institutional rigidities, and adjustment costs are all factors that are likely to prevent fast adjustment in portfolio composition. If these factors are absent, so that adjustment in portfolio composition is fast, then incipient capital outflows ensure that domestic interest rates are always equal to foreign rates plus the expected rate of depreciation.

In the model that emerges, an attempt is made to distinguish short-run from long-run equilibrium because certain markets adjust more quickly than others. In the short run, adjustment to a monetary disturbance is obtained through the exchange rate, and in the long run through real output and employment. Short-run adjustment operates via the expenditure-switching and expenditure-reducing roles of the exchange rate. In its switching role, exchange depreciation changes the relative prices of domestic and foreign goods and encourages substitution of domestic goods for foreign ones. The expenditure-reducing role of exchange depreciation puts upward pressure on consumer prices and real output, because the domestic price of imported goods has risen; this induces an excess demand for nominal money balances. The excess demand for money is reduced by a rise in domestic interest rates, which, in turn, depresses real aggregate demand and reverses the original inflationary process.

In the longer run, domestic prices and wages adjust in order to bring the system into long-run equilibrium. In the steady state, all prices in terms of domestic currency as well as domestic inflationary expectations must grow at the same rate, although domestic inflation may deviate from the world inflation rate by the rate of exchange depreciation. Since the exchange rate is an endogenously determined variable, it follows that the steady-state rate of domestic inflation is also endogenously determined.

Adjustment following a disturbance clearly depends upon the nature of the initial shock and the size of the relevant parameters for the country under examination. For this analysis, an initial monetary shock, in the form of a once-and-for-all increase in the money stock, will be assumed. The resulting price changes are not, however, accommodated by further monetary growth. For descriptive purposes, three different phases of adjustment are distinguished. In phase I, short-run equilibrium in money and commodity markets is achieved at any point in time. The longer-run dynamic system is split into two phases in order to assess the point in time at which countries are most likely to use a policy of monetary accommodation. Domestic prices and wages adjust in phase II, and in phase III the economy moves back to its steady state. In analyzing the adjustment process, consideration will be given to whether adjustment to an exogenous shock will prove more costly (in terms of the level of unemployment) for a small, open economy 4 than for a large, relatively closed economy.

In phase I, a domestic monetary expansion will reduce the domestic interest rate in order to clear the money market. The change in the interest differential will induce capital outflows and a depreciation of the domestic currency. Exchange rate depreciation will continue until incipient capital outflows are equal to the improvement in the trade account. The improvement in the trade account occurs through relative price changes, which produce an excess demand for domestically produced goods and an increase in domestic output. This first phase of adjustment can be described as a beneficial one characterized by rising employment, an improving trade account, and low inflation.

As far as the expenditure-reducing role of the exchange rate is concerned, the larger the share of foreign goods in total expenditure, the larger will be the fall in real balances required to clear the money market. Thus the deflationary effects via real balances will be larger for a small country than for a large country. For any given change in real balances, a lower interest response of money demand will produce a large change in the interest rate and therefore require a large movement in the exchange rate. The short-run equilibrium conditions in the commodity market also define the expenditure-switching role of the exchange rate. The more diversified the economy (a large country assumption), the more possibilities there will be for substitution of domestic goods for foreign ones. Such substitution will lead to a higher elasticity of equilibrium output with respect to the exchange rate at constant interest rates.

In short-run equilibrium, the size of individual country parameters determines whether a country’s exchange rate will initially overshoot its equilibrium value in response to a monetary expansion. The elasticity of output with respect to the exchange rate, the income elasticity of money demand, and the size of expenditures on domestic goods in relation to total private spending tells us whether, at constant interest rates and capital flows, the exchange rate will overshoot. Compared with large countries, small countries will be less prone to overshoot because the share of expenditures on domestic goods in total private spending is low, but more prone to overshoot because the elasticity of equilibrium output with respect to the exchange rate is low. Small countries could be more vulnerable to J-curves because of the speed with which exchange rates are fed into import and export prices, particularly if a small country is not a price taker on the export side. These effects will feed through more slowly for larger countries or for countries that can exert some power over their import and export prices. The beneficial character of this first phase will be moderated if a J-curve exists; under these conditions, currency depreciation must be large enough to induce expectations of a later appreciation and therefore induce capital inflows that will offset the deterioration in the current account.

In phase II, the characteristic features of stagflation begin to show, as prices and wages begin to respond to the monetary expansion. Wage inflation increases, because exchange rate depreciation has lowered real wages through its effect on the domestic price of imported goods. This affects inflationary expectations. In time, inflationary expectations are also changed through the effect of rising domestic prices on real wages. 5 Domestic inflation is caused on the demand side by excess demand for domestic goods, and on the supply side by accelerating costs of imported inputs and nominal wage increases that are passed on into prices. Rising domestic prices decrease the demand for domestically produced goods and are accompanied by a deterioration in the trade account, a fall in real income, exchange rate depreciation, and capital inflows. The second phase of the adjustment process, therefore, shows all the stagflation characteristics of accelerating price and wage inflation, rising unemployment, current account deterioration, and a depreciating exchange rate.

The outcome in phase II is dependent upon how wages respond to price expectations, and domestic prices to excess demand and cost conditions. If workers correctly anticipate the increase in the money supply and if in addition all costs are passed on into domestic prices, domestic prices will rise by the full amount of the cost increases. Domestic prices will also rise higher, the larger is the domestic price adjustment to excess demand for domestic goods and the larger is the wage adjustment to excess demand in the labor market. One major difference between small and large countries is that the effect of import prices on domestic prices will be greater in the former as they go through phase II. Furthermore, although most empirical results now show that in the long run no trade-off exists between unemployment and inflation, in the short run differences between countries might be observed because the effect of the exchange rate on the domestic prices of imported goods is greater for small countries than for large ones; this greater effect will lead to a larger reduction in real wages and generate more pressure on inflationary expectations. 6 Furthermore, the fall in domestic output in response to higher domestic prices will depend upon the possibilities for substitution of foreign goods for domestic ones.

In the third phase, the fall in income and employment allows price and wage inflation to abate. The new steady state is achieved when the adjustment process restores the economy to its initial real equilibrium, with all price increases in terms of domestic currency, domestic inflationary expectations, and exchange rate depreciation occurring at the same rate; the expected future value of the exchange rate equal to the long-run equilibrium value of the actual exchange rate; and the current account in balance.

The analysis shows that if money supply changes are fully anticipated in the long run, changes in the money supply will have no effect on output or the terms of trade under a flexible exchange rate system. Thus unless real wages fall permanently during the adjustment process, monetary policy is powerless to increase real aggregate demand in the long run. Other policies that accelerate technological change, reduce welfare benefits, or reduce unemployment-vacancy relationships can, however, be utilized to reduce the natural rate of unemployment in the long run. The above analysis also demonstrates that an attempt to affect real output by changing monetary policy in an unpredictable manner will lead to highly volatile exchange rate movements. If an expansionary policy leads to a permanent increase in money growth, the economy will reach a permanently higher level of price inflation because of the change in price expectations.

Adjustment following a real shock, such as a rise in import prices of raw materials for which no domestic substitutes exist, will differ slightly from adjustment following a monetary shock, because the initial impact will take place in the goods market. The price rise will be transmitted to the consumer price index and will cause domestic real income growth to decrease as the money market clears. The deteriorating current account will lead to exchange depreciation and higher domestic interest rates as the asset market adjusts. In phase II, wage inflation will become positive and price inflation will accelerate as the rise in import prices is transmitted via the commodity and labor markets; this process will cause unemployment to continue rising until wage and price inflation begin to abate. As domestic inflation slows down, unemployment will stop rising as equilibrium is approached. In phase III, the trade account will begin to improve, and domestic output will increase. In turn, unemployment and domestic inflation will decline until domestic inflation falls sufficiently to offset the foreign inflationary impact and all real variables are at their original levels.

The previous analysis of adjustment is useful because it highlights the desired conditions that are necessary for smooth and stable adjustment to long-run equilibrium. These are (a) monetary policies that are restrained, even when unemployment is high and inflation is beginning to decline, so that the economy may adjust to long-run equilibrium; (b) rates of change of wages and prices that are sufficiently flexible downward as well as upward; 7 and (c) exchange rate expectations that orient the economy to long-run equilibrium.

Without monetary accommodation, a vicious circle cannot continue for any length of time. Either the economy will adjust to a new steady state, or, if real wages and prices are completely inflexible, it will adjust to an unemployment rate that is higher than the initial one. In either case, without money to accommodate higher prices and wages, the vicious circle will fizzle out. If, however, prices and real wages are relatively inflexible downward, so that it takes a deep recession before the economy begins to move to its steady state, then the authorities may have little choice but to accommodate the accelerating inflationary tendencies by further increasing the rate of money growth. The analysis of any vicious circle economy should therefore include a discussion of the motivation behind monetary policy.

In setting the money supply, the monetary authorities are assumed to be responsive to unemployment and inflation. If unemployment is the more important variable, monetary accommodation may occur in phase I of the adjustment process when a fall in real balances is taking place. This produces resistance to the expenditure-reducing role of the exchange rate and moderates the switching effect. The other time monetary accommodation is likely to take place is between phases II and III of the adjustment process when wage and price inflation is beginning to abate in response to unemployment, but unemployment is still high and has not yet begun to fall very much. Accommodation policies are more likely to be followed where prices and wages adjust slowly to downward pressures or where prices and wages are completely rigid, and if there are strong political pressures to reduce the level of unemployment. These policies may provide a short-run cure for unemployment, but the beneficial effect is only temporary; and if increases in prices and wages continue to be accommodated, even this temporary effect may disappear. Indeed, as has been shown, the full effect of these policies is to instigate another stagflation phase of the economy as it moves through another phase II of the adjustment process.

Two important questions pertinent to the vicious circle hypothesis can be answered from the theoretical analysis presented here. The first question is, Can a shock in the foreign exchange market cause a vicious circle? The question is posed because much analysis of vicious circles puts the blame on exchange rates and, in particular, on the flexible exchange rate system. The second question is, Are small, open economies more vulnerable to vicious circles than larger, relatively closed economies?

The expectations-formation mechanism in the foreign exchange market has important implications for the vicious circle and may modify the analysis of the adjustment process presented earlier. Consider, for example, a monetary expansion that increases the differential between the domestic and foreign inflation rates. Under rational expectations, market participants change their portfolios so that speculative capital outflows lead exchange rate depreciation to continue until an anticipation of appreciation corresponding to the interest differential is reached. The exchange rate therefore depreciates by an amount equal to the higher rate of inflation. Other expectations mechanisms may modify the process. The most extreme are extrapolative expectations, which could exaggerate the expected depreciation and lead to bandwagon effects that could result in an exchange depreciation greater than the higher rate of inflation. The different hypotheses on expectations also imply different time lags and speeds with which depreciation and the subsequent feeding through into domestic prices occur.

Several models have been built to assess whether exogenous shocks can lead to a change in expectations about the long-run exchange rate that will cause excessive exchange rate movements in one direction. Survey articles describing these models can be found in Dornbusch (1979), Isard (1978), and Schadler (1977). Examples of disturbances that can lead to excessive exchange rate movements are (1) an unexpected change in the money supply that provokes expectations of a change in its underlying growth rate (Mussa (1976)); (2) interventionist policies by governments combined with frequent revisions of the target exchange rate (McKinnon (1976) and (1979)); and (3) a change in the current account balance that cannot be easily offset by capital flows because of insufficient substitution between domestic and foreign financial assets (Artus and Crockett (1978)).

Although theoretical research shows that expectations can exert downward pressure on the exchange rate that can depreciate it below the level consistent with long-run domestic cost-price relationships, this phenomenon by itself cannot be held responsible for causing a vicious circle, although it is possible that a vicious circle may start in the foreign exchange market. The longer-run properties of the system that were described earlier show that price increases that result from these exaggerated exchange rate effects will be fed into the domestic economy via import prices and excess demand for domestic products. However, as the economy moves along the path to long-run equilibrium, the exchange rate will appreciate, and a fall in domestic prices will take place. The only reason for these excessive exchange rate movements to result in higher prices and unemployment would be that prices and wages are rigid in a downward direction. 8 Even this rigidity is not sufficient to sustain a vicious circle, although it could be argued that the high unemployment resulting from price rigidity results in political pressure on the government to expand the money supply. An endless vicious circle can continue only if the high price/wage levels are accommodated by domestic financial policies.

If we are to conclude that small, open economies are more vulnerable to vicious circles than larger, closed economies, it is necessary to ask whether an exogenous monetary (or real) shock will prove more costly (in terms of the level of unemployment) for a small country than for a large country as the economy moves through the adjustment process. Among other things, the level of unemployment following a monetary shock will depend upon (1) short-run adjustment in the output market following an exchange rate change, and (2) longer-run adjustment of wages and prices to changes in price expectations.

The analysis from the theoretical discussion supports the small-country vulnerability argument, in that small, open countries are price takers with large traded sectors and in the short run are likely to experience more price effects and fewer output effects. Some exchange rate overshooting may occur if the country is not a price taker on the export side. Unemployment and inflation are also likely to be higher for small countries than for large countries as the economy approaches the stagflation phase of adjustment. These factors by themselves, however, are not sufficient to demonstrate small-country vulnerability to the vicious circle, because more deep unemployment may allow long-run equilibrium to be achieved more rapidly than less shallow unemployment. It follows that the factors that are more likely to have caused countries to experience a vicious circle following large exogenous shocks are the poor functioning of the labor market and the inappropriateness of domestic financial policies.

II. Empirical Evidence

The previous section has set out the theoretical framework for analyzing the vicious circle hypothesis. The purpose of this section is to provide information on the magnitude of the key parameters and to identify what features of an economy can be empirically verified as either causing vicious circles or producing vulnerability to vicious circles.

The two key issues to be investigated are (1) how various markets react and (2) what the role of policy is. The first issue will be examined in terms of (a) adjustment in the foreign exchange market, (b) the transmission of the effects of exchange rate changes to the domestic economy, and (c) the wage-price spiral. The second key issue will be examined in terms of the role of the monetary authorities (appropriate and inappropriate policies) and the importance of institutional and political characteristics of the economy. It is, of course, recognized that these two key issues are closely interrelated to the extent that monetary policy may affect some of the key parameters as agents adjust to, and anticipate, monetary policy.

Before proceeding further, it is worthwhile to point out that estimates of the parameters that would satisfy the theoretical framework are difficult to find. Empirical studies may not provide the required information for the following reasons: (1) In some cases, empirical studies make use of a small block recursive system in which variables endogenous to the vicious circle are treated as exogenous. These estimates may be biased and inconsistent when applied to a vicious-circle type of framework. (2) Many of the estimates were developed for purposes other than those sought here; and in order to make comparisons across studies, it has sometimes been necessary to modify results.

transmission of an exogenous shock to the domestic economy

Adjustment in foreign exchange markets

Monetary shocks affect the exchange rate via the interest rate differential, so that a low interest rate elasticity of demand for money will produce large fluctuations in the interest rate and require large changes in the exchange rate. Three recent studies provide estimates of interest rate elasticities for the narrow definition of money (M1) from the same functional form that enables cross-country comparisons to be made. The results are presented in Table 1.

Table 1.Seven Industrial Countries: Estimates of Interest Rate Elasticities UsingM1
StudyCanadaFranceGermany,

Fed. Rep.
ItalyJapanUnited

Kingdom
United

States
Boughton
(1979)–0.19–0.33–0.15–0.41–0.38–0.51–0.06
Coutièe
(1976)–0.38–0.02–1.41–0.30–0.19
Fase & Kuné
(1975)–0.04 to–0.19 to–0.07 to–0.34–0.09 to
(from various studies)–0.63–0.21–0.35–1.05

The evidence seems to indicate a fairly low interest elasticity for most countries, and in particular for the Federal Republic of Germany and the United States. The low elasticities for these two countries are confirmed by studies by Feige and Pearce (1977), Goldfeld (1973), and Hamburger (1977). These results imply that, other things being equal, an expansion of the money supply (or a contraction of the demand for money) of the Federal Republic of Germany or the United States will require slightly larger movements in exchange rates (and capital flows) than would be required for other countries. The lack of large samples, however, does mean that it is difficult to draw many conclusions from these results.

As far as adjustments in foreign exchange markets are concerned, the question this section addresses is whether there is empirical evidence to show that the blame for vicious circles can be put on the flexible exchange rate system. Results from empirical tests on whether expectations have become sufficiently extrapolative to set off excessive downward pressure on the exchange rate have been mixed. On the one hand, tests of the rational expectations hypothesis have been supported by Black (1972) using U.S. capital flows; Frenkel (1976) using the forward premium as a proxy for exchange rate expectations in explaining the behavior of the deutsche mark during the German hyperinflation of the 1920s; and Bilson (1978) by comparing the monthly equilibrium value for the deutsche mark/pound sterling rate with the actual rate. On the other hand, McCallum (1977), using the actual spot rate at t+1 as a proxy for the expected future spot rate at t for the Canadian dollar, and Kohlhagen (1977), using German capital flows, found that their results did not support the rational expectations hypothesis. In other tests, the hypothesis that the foreign exchange market is efficient (Logue and Sweeney (1975) and Dooley and Shafer (1976) has also been refuted by the data.

It seems appropriate to conclude from the empirical results presented that the hypothesis that foreign exchange markets are efficient—that is, that investors cannot create excessive downward pressure on an exchange rate relative to its long-run level—is not supported by the data, so that a vicious circle may start here.

Transmission of exchange rate changes to the domestic economy

In this section, the transmission of exchange rate changes to the domestic economy is analyzed in order to assess what role adjustment in the domestic economy plays and what particular characteristics might make a country more vulnerable to vicious circles. The question of pass-through effects from exchange rate changes to the domestic prices of imports is substantially an empirical one, and there are essentially two ways in which to obtain an indication of these effects: (1) from direct estimates of pass-through effects, and (2) from estimates of the relevant trade elasticities.

Pass-through effects from exchange rates to import and export prices are shown in Table 2. 9 Empirical results from a study by Kreinin (1977) give the pass-through effect on import prices for selected countries after two quarters. These results show that the Federal Republic of Germany, Japan, and the United States exercise considerable market power, with pass-through effects on the import side of 60, 80, and 50 per cent, respectively. The remaining countries show almost complete pass-through after two quarters. On the export side, changes in the exchange rate provoke rapidly offsetting changes in export prices for Austria, Belgium, the Netherlands, and Sweden, as results from the study by Robinson and others (1979) (see Table 2) show. These changes occur within one year for Austria and Belgium, and within two years for the Netherlands and Sweden. Within two years, France, the Federal Republic of Germany, Italy, and the United Kingdom experience between 70 and 90 per cent pass-through, whereas Japan and the United States experience less than 70 per cent pass-through.

Table 2.Fourteen Industrial Countries: Estimates of Parameters to Identify Small-Country Vulnerability to Vicious Circles
CountrySize of Traded

Goods Sector

Relative to

GNP (1972)
Price Elasticities

of Demand for

Imports
Price Elasticities

of Demand for

Exports
Pass-Through Effect

of 1% Change in

Exchange Rate on

Import Prices

(two quarters)
Effect of 1% Change

in Local Currency

Import Prices on

Consumer Prices

Within One Year
Effect of 1%

Change in

Exchange Rates

on Export Prices

over Two Years
TotalManufacturesTotalManufacturesDornbusch and Krugman (1976)Spitäller (1978)Robinson and others (1979)
Stern and others (1976)Deppler and Ripley (1978)Stern and others (1976)Deppler and Ripley (1978)
Salant (1977)Kreinin (1977)
Austria0.31–1.32–0.93–1.041.001.09
Belgium-Luxembourg0.47–0.83–0.47–1.02–3.020.901.38
Canada0.24–1.30–0.85–0.790.900.200.240.89
Denmark0.30–1.05–1.63–1.28–0.930.54
France0.17–1.08–0.82–1.31–1.970.160.360.71
Germany, Fed. Rep.0.21–0.88–0.90–1.11–0.660.600.030.080.93
Italy0.22–1.03–0.931.000.280.360.99
Japan0.10–0.78–1.45–1.25–1.730.800.240.65
Netherlands0.44–0.68–0.95–1.870.92
Norway0.42–1.19–3.11–0.81–2.890.35
Sweden0.25–0.79–2.07–1.96–1.821.10
Switzerland0.35–1.22–1.01–1.571.000.330.69
United Kingdom0.23–0.65–0.43–0.48–0.540.190.240.79
United States0.07–1.66–1.92–1.41–1.520.500.140.160.58

Given these empirical results, it is appropriate to conclude that small countries are likely to experience more price effects 10 as exchange rate changes are fed into the domestic economy. On the one hand, medium-sized and small countries show almost complete pass-through from the exchange rate to import prices after two quarters. Large countries, on the other hand, show only partial pass-through effects. Results on the export side give similar results, as exchange rate changes are passed into export prices.

Price elasticities of demand for imports and exports calculated by Stern and others (total elasticities) and Deppler and Ripley (for manufactures) are also shown in Table 2. These results show that small and medium-sized countries are more likely to have lower trade elasticities than large countries. These are long-run estimates; most empirical studies have shown that short-run elasticities are generally substantially smaller than long-run elasticities.

The greater pass-through of exchange rates into both import and export prices, combined with the tendency for smaller countries to have lower short-run trade elasticities, shows that small countries may be more vulnerable to short-run J-curves than large countries, and consequently may experience some exchange rate overshooting as a result of exchange depreciation.

Unemployment and inflation are therefore likely to be higher for small countries than for large countries as their economies approach the stagflation adjustment phase.

Wage-price spiral

Of great importance for the vicious circle is the way that wages respond to excess supply conditions in the economy and how inflationary expectations respond to changes in prices. Two different threads of theory, related but separable, have been developed about the relationship of wages to an excess demand or supply in the labor market; each of them leads to a very different conclusion about the attainability of a new steady state following an exogenous disturbance. The first is that developed by economists (Hicks (1974) and (1975); Scitovsky (1978)) who maintain that a large part of the labor market is uncompetitive. An expansionary shock (real or monetary) can cause the real wage level to be out of equilibrium because the concept of a fair wage (based on a comparison with others’ wages) can allow a rise in wages in the competitive sector to generate pressure for wage increases in the noncompetitive sector. The real wage can then remain out of equilibrium because of real wage resistance, which is based on a worker’s comparison with his own experience in the past and makes him resist a reduction in his real wage. Wage indexation schemes, contractual collective bargaining, government commitment to a high employment policy, and unemployment schemes all encourage real wage resistance. This inertia view is consistent with vicious circle patterns; it implies that the response of wages to excess supply conditions in the labor market is low and that inflationary expectations do not change even when restrictive policies are used.

The second argument is that developed by Friedman (1968) and his followers. In their view, most of the labor market is competitive, so that a level of unemployment above the natural rate will lead to rapid downward pressure on wages. Inflationary expectations adjust rapidly to restrictive demand policies as workers realize they are overestimating the domestic rate of inflation. This theory implies that expectations about the inflation rate can be altered relatively quickly and at little unemployment cost by a previously announced restrictive monetary policy. Thus wages are highly responsive to excess supply conditions in the labor market, and inflationary expectations can be changed so long as monetary policy is not accommodative.

The response of wages, therefore, not only depends on the labor market situation but also reflects the differences in policies between countries and the effects that these policies have upon expectations. An accommodating monetary policy will, in general, lead workers not to adjust inflationary expectations and, therefore, not to moderate wage demands in the face of unemployment.

Information on the response of wages to unemployment and the response of wages to prices has been obtained from econometric studies. Most of these studies confirm that there is no long-run trade-off between unemployment and inflation; thus the discussion will focus on the response of wage inflation to a rise in the unemployment rate and the short-run response of wages to price expectations. Given the number of studies on the Phillips curve, it would seem that no problem exists in identifying these parameters. However, the results of empirical Phillips curve studies are deficient in many respects. First, it is difficult to estimate the impact of unemployment on wage changes, because it is likely that the natural rate of unemployment has not been constant over time. Changes in monetary policies as well as periods of wage indexation are also likely to change the value of this parameter. Second, wage changes are influenced more strongly by “inflationary expectations” than by actual price changes; and since it is difficult to obtain data on inflationary expectations, most empirical studies proxy the expected price change by a distributed lag on actual price changes. 11 One weakness of this approach is that it ignores the direct effects of anticipated monetary changes on inflationary expectations. Third, many equations are estimated by using the unemployment rate as a proxy for the excess demand for labor. Therefore, equations often incorporate the joint hypothesis that a change in wages is a function of the excess demand for labor and that a stable relationship between the excess demand for labor and the unemployment rate exists. Others use Okun’s law to derive excess capacity as a proxy for the excess demand for labor. Fourth, most of the empirical estimates obtained are derived from partial equilibrium analysis, which treats unemployment, and in some cases consumer prices, as exogenously determined. These results do not allow for full feedback from wages to the excess demand for labor. Two studies included here, Bergstrom and Wymer (1976) and Knight and Wymer (1978), are of a general equilibrium form, however, and treat both unemployment and prices as endogenously determined.

Keeping the limitations mentioned above in mind, the results of the empirical studies seem to suggest a number of conclusions, which are summarized in Table 3, with respect to the response of wages to unemployment. An examination of the first-year effects of a 25 per cent increase in the unemployment rate from its natural rate (where the natural rate is proxied by the mean rate of unemployment over the period of estimation) suggests that (1) The estimates vary considerably across countries, whereas within countries the parameter estimates obtained from different studies are fairly close for some countries, suggesting that the response of wages to unemployment may be reasonably stable and may differ considerably across countries; (2) A hypothetical 25 per cent increase in the unemployment rate results in a large reduction in the rate of change of wages in Canada, France, the Federal Republic of Germany, Japan, and the Netherlands. The sensitivity of wage changes to variations in the unemployment rate appears to be much less in the United Kingdom, while the responses suggest that sensitivity is lowest in Italy, Sweden, and the United States.

Table 3.Nine Industrial Countries: Estimates of Effect on Wage Inflation of 25 Per Cent Rise in Unemployment Rate from Its Natural Rate, and of First-Year Response of Wage Inflation to Price Inflation
AuthorChange in Wage

Inflation

Resulting from

25 Per Cent Rise in

Unemployment Rate

(1)
First-Year

Response of

Wages to Prices1

(2)
Time

Period

(3)
Data 2

(4)
Canada
Perry (1975)–1.500.1841964–72A
Turnovsky (1972)–1.050.7361949–69SA
Bodkin and others (1967)–1.080.6021953–65Q
France
Bodkin and others (1967)–1.021954–65Q
Germany, Fed. Rep.
Perry (1975)–1.000.2401963–72A
Boelaert (1973)–0.810.5001955–69A
Italy
Modigliani and Tarantelli (1977)–0.211.021952–73A
Japan
Perry (1975)–0.601964–72A
Toyoda (1972)–1.400.4801956–68Q
Netherlands
Perry (1975)–0.800.0871962–72A
Boelaert (1973)–1.350.5901955–69A
Sweden
Perry (1975)–0.301963–72A
United Kingdom
Perry (1975)–0.500.2401962–72A
Lipsey and Parkin (1970)–0.370.4801948–68Q
Goldstein (1974)–0.540.5101954–71Q
Bergstrom and Wymer (1976)–0.160.5501955–66SA
Knight and Wymer (1978)–0.561955–72Q
Bodkin and others (1967)–1.090.3801954–65Q
United States
Perry (1975)–0.300.1991960–72A
Pierce and Enzler (1974)–0.400.5251958–73Q
Perry (1978)–0.350.5801957–72A
Black and Kelejian (1972)–0.540.2001954–77Q
Bodkin and others (1967)–0.470.2201953–65Q

In most cases, the estimated value of the parameter for one year refers to the consumer price index. In some cases, the domestic price index and import price index were included as separate variables in the equation, and the estimates refer to the sum of the estimated coefficients of these two variables.

A denotes annual data; SA denotes semiannual data; and Q denotes quarterly data.

In most cases, the estimated value of the parameter for one year refers to the consumer price index. In some cases, the domestic price index and import price index were included as separate variables in the equation, and the estimates refer to the sum of the estimated coefficients of these two variables.

A denotes annual data; SA denotes semiannual data; and Q denotes quarterly data.

A cross-country comparison of the estimates presented in column 2 of Table 3 would seem to indicate that there is more variation between different studies in the same country than across countries for the response of the rate of change of wages to the rate of change of prices after one year. There appears to be very little agreement about the size of this short-run parameter, so that these results should be treated cautiously. Taking the mean of the parameter estimates for each country, the evidence suggests that the rate of change of wages is less responsive to variations in the rate of change of consumer prices in the Federal Republic of Germany and the United States 12 than in Canada and the United Kingdom. The greatest sensitivity of wages to changes in prices appears to be found in Italy and Japan. The coefficient for Italy is not significantly different from one in the short run.

The results in Table 3 have been used to assess the present costs associated with getting the economy back to its steady state. An assessment of the costs of maintaining some slack in the economy in terms of its anti-inflationary benefits is made by using the results by Perry (1975) for Canada, the Federal Republic of Germany, Japan, Sweden, the United Kingdom, and the United States; Bodkin and others (1967) for France; and Modigliani and Tarantelli (1977) for Italy. These results are presented in Table 4. In terms of the short-run trade-off between inflation and unemployment, the anti-inflationary benefits of policies that lead to an increase in unemployment of one percentage point above its natural rate for one year and then allow it to return to its natural rate are assessed for eight industrial countries. These results should clearly be treated with caution because of the estimation difficulties mentioned earlier and because the estimates reflect the policy framework of a country. If the policy framework changes, the results will also change.

Table 4.Eight Industrial Countries: Costs Associated with Getting Their Economies Backto Their Steady States(In percentage points)
CountryReduction in Inflation

Rate Associated with

1 Percentage Point

Rise in Unemployment

Rate for One Year
Rise in Unemployment

Rate Necessary

for 1 Percentage

Point Reduction in

Inflation Rate
Germany, Fed. Rep.2.4380.41
France1.94010.51
Japan1.21010.83
Canada1.1230.89
Sweden0.4202.38
United States0.2454.08
United Kingdom0.1109.09
Italy00

In the estimated equations for France and Japan, lagged wages were used as a proxy for prices; the resulting coefficients were used to make these calculations.

In the estimated equations for France and Japan, lagged wages were used as a proxy for prices; the resulting coefficients were used to make these calculations.

For an extra one percentage point in the rate of unemployment maintained for one year, the estimated reduction in the ultimate inflation rate at equilibrium unemployment is least advantageous for Italy, Sweden, the United Kingdom, and the United States and most advantageous for Canada, France, the Federal Republic of Germany, and Japan. These results also illustrate that the costs associated with reducing the inflation rate by 1 per cent are much higher in terms of unemployment for some countries than for others. The coefficient on the rate of change of prices for the equation estimated for Italy is not significantly different from one in the short run, so that no short-run inflation-unemployment trade-off can be assumed for that country. This may be a result of Italy’s institutional and legal practices, which tie wages explicitly to prices through escalator clauses.

Three factors that may be responsible for the differing results given previously are (1) The differences in the behavior of the authorities and unions and the effect that government policies have on expectations. An accommodating monetary policy combined with militant trade union behavior or indexation policies will lessen the response of wages to unemployment and create inflationary expectations that are rigid in a downward direction. The study of results presented here is particularly hampered by the lack of empirical studies that directly assess how accommodative monetary policies affect the parameters. (2) The institutional structure that affects the labor market and, in particular, the organization of the trade unions (which are more fragmented in the United Kingdom than in the Federal Republic of Germany) may explain in part why wage-unemployment and wage-price relationships differ from country to country. Fragmentation is likely to increase the frequency of small disputes, some of which can have quite disruptive effects over a large segment of the economy. In the United Kingdom, pay rises in the public sector have also often been more difficult to control than in most industrial countries. (3) Productivity growth rates differ across countries, and this has a direct effect on the wage-unemployment, wage-price relationships because the rate of productivity growth determines the rate of increase in money wages that can be absorbed without consumer prices increasing.

A further question that has important implications for the role of the labor market in a vicious circle country is whether the parameters are constant over time, or how they might be affected by monetary policy. A study by Fratianni and Korteweg (1976) provides interesting insights. They find that the value of the inflation-output trade-off coefficient has declined significantly over the period 1953–73 compared with the period 1953–67 for the Federal Republic of Germany, the United Kingdom, and the United States.

There is also some evidence to suggest that it becomes more difficult to increase output for vicious circle countries because the policy of continuous monetary expansion increases the speed of price and wage adjustment. Spitäller (1978) has found evidence that the lag between money and prices is shorter in higher-inflation periods; money supply changes, the output gap, and import prices were found to affect inflation almost three times as fast after 1973 as they did on average over the period 1958 to 1976. Knight and Wymer (1978), in an extended version of a model by Bergstrom and Wymer (1976), estimate the mean time lag required for the price level to adjust to a change in the marginal cost (where marginal cost is measured as the wage rate times the marginal product of labor multiplied by a constant) to be two quarters over the period 1955–72, compared with an estimated lag of two years over the period 1955–66 in the earlier model. This evidence suggests that as an economy moves into a higher-inflation period, price adjustment will be more rapid. It may therefore be inferred that the more a vicious circle is prolonged by expansionary monetary policy, the more rapid price adjustment will become, as producers’ expectations adjust and costs are passed rapidly into prices with very little supply response.

To conclude this section on the wage-price spiral, the question of whether major differences exist between the parameters of small and large countries needs to be addressed. One major difference between small and large countries is that the effect of import prices on domestic prices will be greater for small countries as they go through the second phase of adjustment; and the results from studies by Dornbusch and Krugman (1976) and Spitäller (1978) that are given in Table 2 support this statement. In terms of the other key parameters, however, there is no difference between small and large countries.

role of policy

The theoretical and empirical evidence examined so far has tended to focus on adjustment in the absence of government intervention. At least three types of policy stance can have a direct impact on the adjustment process: (1) the adoption of wage indexation schemes that allow wages to adjust rapidly to higher rates of inflation, (2) the pursuit of an accommodating monetary policy, and (3) the attempt to stabilize the exchange rate through intervention in the foreign exchange market. When massive government intervention that cannot be sustained is accompanied by both wage indexation and accommodative monetary policy, an unstable adjustment process, whereby a large downward exchange depreciation is rapidly fed into domestic prices and then accommodated by further monetary expansion, may well occur.

Braun (1976) has found that during the 1970s the two countries that experienced vicious circle problems are also the two countries with the most widespread wage indexation policies (see Table 5, column 8). The argument that indexation policies, combined with expansionary monetary policies, are largely responsible for wage resistance in Italy and the United Kingdom has also been put forward by Sachs (1979 a). 13 He has calculated evidence of real wage resistance in the two years following the oil price increase of 1973–74 by comparing the actual and equilibrium wage rate. The figures shown in columns 6 and 7 of Table 5, which were computed by Sachs, 14 show the percentage of excess wages above their equilibrium level for 1975 and 1976. By 1976, only Italy and the United Kingdom showed signs of real wage resistance, with real wages in excess of the equilibrium wage by 11.5 to 17 per cent. Stage III of the indexation policy adopted in October 1973 in the United Kingdom and the indexation policy adopted in January 1975 in Italy (which provided for 100 per cent indexation for most of the labor force), combined with expansionary monetary policies, are largely responsible for this real wage resistance.

Table 5.Seven Industrial Countries: Unemployment Rates, Excess Wages, and Wage Indexation
Unemployment Rate 1Excess Wage Sachs (1979 a)Wage

Indexation
Country1972

(1)
1973

(2)
1974

(3)
1975

(4)
1976

(5)
1975

(6)
1976

(7)
Braun (1976)

(8)
Per cent
Canada6.25.65.46.97.10.0–2.0Relatively unimportant
France2.82.73.04.24.62.51.0Prohibited
Germany, Fed. Rep.0.80.81.73.73.67.53.5Prohibited
Italy6.76.55.96.36.721.017.0High (almost 100% since 1975)
Japan1.41.31.41.92.01.1–5.1Relatively unimportant
United Kingdom4.23.22.84.76.413.811.5High (1973–74 Stage II incomes policy encouraged cost-of-living adjustments)
United States5.64.95.68.57.70.00.0Relatively unimportant

Using U.S. concepts.

Using U.S. concepts.

The argument that expansionary monetary policies, adopted during adjustment to an exogenous shock, can induce unstable adjustment can be explored by considering the pattern of monetary policies in the major industrial countries. One important characteristic that emerges from looking at the role of monetary policy in the seven major industrial countries is that a counter-cyclical reaction pattern seems to go with virtuous circle countries, while an accommodating policy is much more likely for vicious circle countries. Gordon (1977) has presented a study of inflation and the behavior of monetary authorities that suggests that prior to flexible exchange rates in 1973, growth rates in the money supplies of the Federal Republic of Germany and Japan appear to have followed a counter-cyclical reaction pattern, whereas accommodation was the rule in Italy and the United Kingdom.

In a more detailed study, Black (1978) has documented the policy response of eight major industrial countries to exogenous shocks in the 1970s. His summary table of the direction of fiscal and monetary policies for the years 1972 to 1976 is shown in Table 6. Care should be taken in interpreting this table, especially for a country such as Italy for which the turning points in policy often come at mid-year. The table can be used to assess countries’ monetary and (monetary financing of) fiscal policies following two major exogenous shocks that took place in the first half of the 1970s—the collapse of the Bretton Woods system in 1970–72 and the Organization of Petroleum Exporting Countries (OPEC) oil price rise of 1973–74.

Table 6.Eight Industrial Countries: Use of Monetary and Fiscal Instruments, 1972–76 1
19721973197419751976
Canada
Monetary+–/+
Fiscal++++
France
Monetary++
Fiscal++/-+0
Germany, Fed. Rep.
Monetary+++
Fiscal+++
Italy
Monetary+000
Fiscal++0+
Japan
Monetary+++
Fiscal++/00++
Sweden
Monetary+++
Fiscal+
United Kingdom
Monetary+000
Fiscal++++0
United States
Monetary+++
Fiscal++

+ = expansionary; – = contractionary; 0 = neutral.

+ = expansionary; – = contractionary; 0 = neutral.

The table shows that the money supplies of most industrial countries expanded considerably in 1972, following the breakdown of the Bretton Woods system in 1971 and the subsequent increase in liabilities to foreign central banks. Most countries did not offset the growth in international reserves, because they coincided with the 1970–71 recessions in the major industrial countries. Black has documented that money growth in 1972, as a percentage of M2 in the previous year, exceeded the average rate of growth during 1962–71 by 20 per cent in the United Kingdom, 8 per cent in France, 8 per cent in Italy, 6 per cent in Japan, 5 per cent in Canada, 4 per cent in the United States, and 2 per cent in the Federal Republic of Germany. The inflationary boom that resulted in 1973, with real growth near or above its potential, suggests that countries were moving toward the second phase of stagflation and accelerating price and wage inflation. At this phase, a difference in policy stances across countries emerged.

By 1973, monetary growth in the Federal Republic of Germany and Japan had slowed significantly. By contrast, monetary growth in the United Kingdom was at 27.5 per cent as a result of the priority given to growth by the Conservative Government. Money growth had also expanded to 23.5 per cent in Italy. Table 6 shows that France and the United States had also moved to more restrictive fiscal policies in 1973, and that Sweden continued its restrictive policy, in attempts to reduce inflation and move their economies to their long-run equilibria. Canada, Italy, and the United Kingdom, by contrast, all had expansionary fiscal policies. The second shock, the 1973–74 oil crisis, therefore hit many countries as the adjustment process was beginning to take place. Although all countries were moving toward a recession as a result of the oil shock, the policy reactions differed. The Federal Republic of Germany, Japan, and the United States tended to use relatively tight monetary policies in an attempt to allow their economies to adjust. Looser fiscal and monetary policies were followed in Italy and the United Kingdom.

The first five columns of Table 5 show how unemployment rates varied across countries as adjustment to the Bretton Woods collapse and the oil crisis took place. From 1972 to 1974, the unemployment rate in the United Kingdom fell from 4.2 to 2.8 per cent, in Italy from 6.7 to 5.9 per cent, and in Canada from 6.2 to 5.4 per cent. In all other countries, unemployment either remained constant or rose. Not until 1976 in the United Kingdom and 1976/77 in Italy did the authorities actively control the money supply and permit unemployment to rise in an effort to allow long-run adjustment to take place.

These examples highlight the differences in policy approaches of countries in the aftermath of the 1974 oil price shock. On one side were the countries that were more concerned with maintaining growth in domestic output and that were more likely to accommodate current inflation than allow unemployment to rise. To continue these expansionary policies while keeping the exchange rate from depreciating too much, they borrowed abroad. These policies, which led to a weakening of their current accounts, were continued until 1976, when it became clear that they were not sustainable and that adjustment would have to take place. On the other side were countries that were more concerned with inflation and made more of an effort to adjust. They accepted slower growth rates and higher unemployment as the cost associated with controlling inflation. These policies helped to strengthen their current accounts and exchange rates. Most countries fell somewhere between these two policies. Clearly, some countries started in a healthier position than others. For example, it would be easier for a country with an undervalued exchange rate to adjust than for one with an overvalued exchange rate.

III. Conclusion

It is quite clear, both theoretically and empirically, that the difference between vicious and virtuous circle experiences is primarily determined by the difference in the policies of the monetary authorities. Some countries tend to accommodate price increases by money supply increases, and others do not, or at least do not do so to the same extent. The difference in monetary policies can often, however, be explained by the fact that the costs associated with getting an economy back to its steady state after an inflationary disturbance are much higher for some countries than for others. In many cases where it appears that a long and deep recession is necessary before adjustment will take place, the authorities often feel that they have no realistic alternative but to accommodate price-wage inflation. The exchange rate by itself seems to play a minor role in either starting a vicious circle or allowing one to continue, although the risk that the exchange rate may play such a role is clearly higher in cases of small, open economies.

Solutions to the vicious circle must, therefore, be found in two directions. First, ways must be found to decrease the cost of stopping a vicious circle in terms of unemployment—a cost that at present seems extremely high in many countries because of market imperfections and persistent inflationary expectations. Second, the authorities must make the public more aware that it is better to pay the cost of adjustment now rather than later; stopping a vicious circle of domestic price increases and exchange rate depreciation will prove to be more and more costly in terms of unemployment the longer the stabilization policy is delayed. This educational campaign is essential in order to make the implementation of the necessary stabilization program politically feasible.

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*

Ms. Bond, economist in the External Adjustment Division of the Research Department, is a graduate of the University of Essex and of the London School of Economics and Political Science. She was formerly a member of the faculty of the University of Reading, England.

1

The idea of a vicious circle of inflation and exchange rate depreciation is not new. For an early review of the inflation-exchange rate spiral, see Gottfried Haberler (1937), pp. 44–46 and 55–61.

2

A paper on this topic giving the extended vicious circle model in more detail is available on request from the author, whose address is: Research Department, International Monetary Fund, Washington, D.C. 20431.

3

Dornbusch and Krugman (1976) explain how this assumption gives rise to a capital flow function.

4

A small, open economy is defined as one that has a relatively large traded goods sector and that exports a large share of its output.

5

The response of the labor market and output to an increase in the money supply is dependent upon whether the monetary shock was anticipated or unanticipated. The reduction in the real wage rate following an unanticipated monetary shock will last longer than the real wage reduction following an anticipated monetary shock. Therefore the resulting rise in output will also be longer lasting when the monetary shock is unanticipated.

6

The relative size of the open sector of an economy will also influence the speed with which wage increases in the traded goods sector affect wage increases in the nontraded goods sector.

7

Argy and Salop (1979) in a static model of price and output determination under flexible exchange rates show how real-wage rigidity can explain the vicious circle of inflation and exchange rate depreciation.

8

Basevi and de Grauwe (1977), in a comparative static framework of the Dornbusch asset market model (assuming rational expectations), show that short-run fixity of the interest rate, combined with short-run overshooting of the exchange rate and a situation where prices are rigid downward, will lead to higher prices and higher unemployment than would occur if prices were completely flexible.

9

Some of the empirical estimates presented in this section should be treated with caution because most are derived from studies that do not use simultaneous equation techniques. The increase in domestic prices when the exchange rate is endogenous can differ in two respects from the analysis where the exchange rate is exogenous. (For more detail on the endogeneity of the exchange rate, see Hooper and Lowrey (1979).) First, factors that cause exchange rate changes can affect domestic prices independently of their impact through the exchange rate. Second, feedback effects will influence the initial inflationary impact of an exchange rate change. If the feedback effects of induced changes in domestic variables are ignored, then biased and inconsistent parameter estimates may well result.

10

This conclusion is supported by evidence from Robinson and others (1979) that two large countries—Japan and the United States—show large divergences between the movements of internal prices and the exchange rate.

11

Actual price changes are, in general, proxied by the consumer price index. In more sophisticated studies, they are proxied by domestic prices and import prices.

12

This result is supported by evidence from Sachs (1979 b) that the United States belongs to a class of countries with “short-run sluggishness” in nominal wages because of the contractual length of wage agreements.

13

Fischer (1977) and Gray (1976 and 1978) also provide evidence of the effects of indexation schemes on the adjustment process.

14

Sach’s equilibrium wage level is calculated on the assumptions that (1) real wages in 1972 were at an equilibrium level; and (2) the full-employment share of labor income in total income is constant. Full-employment real wages for 1975 and 1976 are calculated by using Artus and Turner’s (1978) estimated potential output per man-hour in manufacturing. The equilibrium real wage is calculated by adjusting the 1972 real wage for four years of trend productivity growth and for terms-of-trade changes.

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