I. Introduction

An important area of investigation in development macroeconomics has been the determination of the degree of wage flexibility and the speed of international capital mobility. Recent findings suggest that the labor market in developing countries is often characterized by nominal wage rigidity--in contrast with the common, and often implicit, assumption of real wage resistance in the early development literature--and, on the financial side, by imperfect capital mobility. Although the literature remains somewhat unsettled on issues such as the exact nature of the expectational mechanism that best characterizes the formation of inflationary expectations embedded in wage contracts, it has been argued that nominal wage inertia--which is often viewed as one of the principal causes of the persistence of inflation in semi- industrialized countries--represents one of the main features of the labor market in a large number of Asian and Latin American countries. Similarly, there exists a growing consensus that the assumption of perfectly mobile capital may not be a sensible approximation for developing countries (in contrast to industrial countries), although the degree of capital mobility appears to vary substantially between upper middle-income developing nations and low-income countries. ^1/

Wage rigidity and imperfect capital mobility have important implications for macroeconomic management, many of which have long been recognized by economists. The literature on contractionary devaluation, for instance, has emphasized the potentially perverse effect that wage formation may play in the transmission process and the ultimate effects of exchange rate changes (Agénor and Montiel, 1994, chapter 7). Similarly, the speed of capital mobility has been shown to play an important role in explaining the behavior of interest rates and the dynamics of portfolio adjustment induced by domestic monetary and fiscal policy shocks. However, both features have not so far been integrated simultaneously in a setup deemed appropriate for macroeconomic policy analysis in developing countries.

This paper attempts to provide such a framework. It examines the implications of both backward- and forward-looking contracts for the long-run effects of macroeconomic policy shocks, using a specification of wage contracts first proposed by Willman (1988). Section II develops the analytical framework, which consists of a two-sector, three-good optimizing model with endogenous mark-up pricing in the nontraded goods sector. Section III studies how alternative assumptions regarding contract formation affect the dynamic structure

(iii) FDI in search of a low-cost labor force promotes conditions (a) and (b) by shifting production locations of labor-intensive products to developing countries (Helpman (1984) and (1985)). As a result, when developed countries expand exports of capital-intensive intermediate inputs and final products and imports of labor-intensive products, both intra-industry and intra-firm trade increase.

These explanations of the static and dynamic trade patterns seem to fit the pattern of trade between Japan and the rapidly industrializing Asian countries. Since the post-war period, these Asian countries have promoted industrialization policies that have led to strong economic growth in the 1980s. From the beginning, the Newly Industrializing Economies (NIEs)-- Hong Kong, Korea, Singapore, and Taiwan Province of China--selected an export-promoting industrialization policy because they lacked natural resources and had small domestic markets. By contrast, the Association of Southeast Asian Nations (ASEAN), which includes Indonesia, Malaysia, the Philippines, and Thailand, initially selected an import-substituting industrialization policy and later adopted an export-promoting industrialization policy. In both cases, the rapid pace of industrialization in these Asian countries changed their pattern of trade with advanced countries like Japan to a considerable degree.

Appealing to the new trade theories, this paper analyzes the changes in trade patterns between Japan and five other Pacific Basin countries over the 1975-85 period. Indonesia, Korea, Malaysia, Singapore, and Thailand have been selected for the purpose of examining the deepening economic linkages in the region. In order to obtain trade data on intermediate inputs, final products, and on sellers and buyers specified by country and industry, we utilize data of the International Input-Output Tables for the years that were available--1975 and 1985.

It should be noted that deepening economic linkages between Japan and the five Pacific Basin countries were already in evidence before 1985. We therefore believe that a detailed analysis of the structural changes before 1985 is important to understanding the growing international division of labor that has been taking place in the Pacific Basin countries during the post-1985 period.

Before moving to the discussion, it seems appropriate to mention some limitations of the paper. First, it does not examine the impact of trade liberalization on the structure of trade, nor does it cover the changes in international trade that have taken place since the appreciation of the yen in 1985, when Japan increased its FDI to the five Asian countries being examined. Further, it does not analyze the impact of increased FDI from Korea and Singapore to other labor-abundant Asian countries in the 1980s--whether this financial assistance may have contributed to deepening the international trade linkages in the region or led to an expansion of intra-industry trade between the more industrialized and less industrialized Asian countries. Thus, the paper does not consider the impact of the recent movement toward intra-regional economic integration on the structure of trade in the Pacific Basin. Although these issues are beyond the scope of this paper, they are important topics for future research.

This paper consists of six sections. Section II undertakes an overview of the economic linkages between Japan and the five Asian countries. Section III analyzes the static and dynamic pattern of trade between the countries by considering intra- and inter-industry trade. Section IV focuses on static and dynamic import-export structures of the Japanese manufacturing industries. In particular, the section focuses on two types of trade flows of manufactured products. One type is of intermediate inputs imported by the Japanese manufacturing industries and the resulting input relationships established with the interacting industries. The other type is of manufactured products produced by the Japanese manufacturing industries and exported as intermediate inputs, and the resulting output relationships created with the associated industries. Section V undertakes an overview of the trends in trade since 1985. Section VI contains concluding remarks.

II. Overview of the Economic Linkages Between Japan and the Pacific Basin Countries

The intra-regional economic linkage between the Pacific Basin countries has deepened significantly in recent years and is clearly observed in international trade transactions between the countries. More than half the exports and imports of the fourteen Pacific Basin countries (including Canada and the United States) were transacted between these countries. For example, in 1984, exports and imports of countries within the region reached 61 percent and 58 percent of their total exports and imports. This intra-regional trade is considered high, particularly when compared with intra-regional trade in the European Union, whose exports and imports achieved 52 percent and 50 percent, respectively (Kraus and Lutkenhorst (1986)).

While the deepening of the intra-regional economic linkage can be partly attributed to a wave of trade liberalization or a political movement toward intra-regional economic cooperation, it is also the result of strong endogenous market forces along the “international production cycle” (Vernon (1966)). According to the international production cycle theory, in the first stage the production of labor-intensive products takes place, such as consumer electronics, processed food, and textiles. Also, the production of heavy industrial products, such as metals, refined oil products, and chemicals, is initiated at this stage. These products are usually produced through import-substitution programs. In the second stage, countries experience an increase in labor costs. In this stage, countries increase productivity in the labor-intensive industries by introducing advanced technology, upgrading their products, or beginning production of higher value-added products. At the same time, heavy industries become competitive, catching up to international standards. In the third stage, countries finally lose competitiveness in the labor-intensive industries. These industries are gradually phased out and as a consequence, firms shift costs--so that υ′ < 0--but entails diminishing returns (υ″ > 0). ^1/ The term π_ta_t accounts for capital losses on total wealth resulting from inflation, while the term $b_t^{*}{\epsilon }_t$ represents capital gains on the stock of foreign bonds resulting from exchange rate depreciation. The last term in equation (3) (where γ > 0) represents an additional tax on foreign bonds, which rises at an increasing rate with actual holdings. Such a tax may be imposed by the government as a result of distributional considerations. ^2/ As shown below, it implies that domestic and foreign bonds are imperfect substitutes, with γ being interpreted as a measure of the degree of capital mobility.

Using (2′), equation (3) can be written as

where ρ_t = (1-ι)i_t - π_t denotes the after-tax domestic real rate of interest.

In the first stage of the consumption decision process, households treat π_t, ε_t, q_t, i_t, $i_t^{*}$ and τ_t as given and maximize (1) subject to (3′) by choosing a sequence ${\left\{c_t,m_t,b_t,b_t^{*}\right\}}_{t=0}^{\infty }$. ^3/ The required optimality conditions are given by:

and the transversality condition $\underset{t\to \infty }{l\mathit{im}}\left(a_t{e}^{-\mathit{\alpha t}}\right)=0$. λ_t, the costate variable associated with the flow budget constraint, measures the shadow value of the representative household’s wealth.

Equation (4a) shows that total consumption is inversely related to the marginal utility of wealth, whose dynamics are described by equation (4d) as a function of the difference between the discount rate and the real after-tax interest rate. Equation (4b) equates at the margin the benefit from holding an additional unit of money (the associated reduction in transactions costs) to its opportunity cost, given by the after-tax domestic nominal interest rate. It determines implicitly the demand for real money balances. Equation (4c) indicates that holdings of foreign bonds depend positively on the difference between the after-tax rates of return on foreign and domestic assets. When the tax parameter γ → 0, equation (4c) yields the uncovered interest parity condition $\left(1-\iota \right)i_t=\left(1-\iota \right)i_t^{*}+{\epsilon }_t$. By contrast, when the tax parameter γ is large, holdings of foreign bonds tend to zero. In such conditions, the domestic interest rate becomes independent of the world interest rate. ^1/

Equation (4b) can be written as

which shows that the demand for money depends positively on the level of transactions--as measured by total consumption expenditure--and negatively on the after-tax nominal interest rate. Substituting equations (4b) and (5) in (4a) yields

where ℙ() denotes the effective price of total consumption in period t. This price is equal to the direct price of the consumption bundle plus the transactions costs associated with purchasing goods, augmented by the opportunity cost (net of taxes) of holding domestic money balances to facilitate transactions. An increase in the after-tax nominal interest rate, given the marginal value of wealth, raises transactions costs as well as the opportunity cost of the existing stock of real money holdings, therefore raising the marginal cost of consumption. The effective price is thus positively related to the opportunity cost of holding real money balances. The above equation can also be written as

In the second stage of the consumption decision process, the representative household maximizes a sub-utility function v[c_N(t), c_I(t)], which is assumed to be homogeneous of degree one, subject to the static budget constraint:

where P_N(t) denotes the price of the home good, $P_I^{*}$ the world price of imports--which is constant and set to unity in what follows--c_N(t) purchases of nontraded goods, and c_I(t) expenditure on imported goods. The solution to this program yields the familiar result according to which the representative household sets the marginal rate of substitution between home and foreign goods equal to their relative price z_t ≡ E_t/P_N(t), that is, the real exchange rate. Using this condition, together with equation (7), and assuming that the sub-utility function is Cobb-Douglas--so that expenditure shares are constant--yields the appropriate definition of the domestic consumer price index, P_t:

where δ denotes the share of total spending falling on home goods. Consequently, using equations (7) and (8) yields

III. Contract Formation and Dynamic Structure

The analytical framework developed in the previous section can be used to study the effects of a variety of macroeconomic policy shocks. Before doing so, however, it is convenient to re-write the model in a more compact form in order to characterize its dynamic structure.

The definitional equation for z_t yields

or, using equations (10), (11) and (12):

Substituting equations (16′) and (17′) in the above expression implies, with backward-looking wage contracts:

and with forward-looking contracts:

Suppose now that the central bank sets the rate of growth of nominal credit so as to compensate the government for the loss in value of the real outstanding stock of credit due to inflation (μ_t = π_t). Under this rule, ḋ_t. Assume also that the government foregoes the issuance of bonds to finance its deficit and instead varies lump-sum taxes so as to balance the budget. Equation (22) yields therefore

where $\tilde{b}$ and $\tilde{d}$ denote the constant levels of domestic bonds and credit, which are normalized to zero in what follows. Substituting equations (7), (11), (15) and (26) in (3′) yields ^1/

which represents the consolidated flow budget constraint of the economy. ^1/ From the equilibrium condition of the money market (equation 23), the domestic interest rate is given by

Substituting this result in equation (6) yields

An increase in the real money stock raises aggregate consumption because the associated expansion in the money supply reduces the domestic interest rate, which stimulates private spending. A rise in the shadow value of wealth lowers directly private expenditure, for a given level of the domestic interest rate.

Substituting equation (29) back in (28) yields

where Φ() = i[m_t, c(λ_t, m_t)]. In general, the net effect of a change in real money balances on the nominal interest rate is ambiguous. On the one hand, an increase in the real money stock requires a fall in domestic interest rates to maintain equilibrium in the money market. On the other, however, the fall in interest rates tends to reduce transactions costs and the opportunity cost of holding money, thus increasing consumption spending and partly offseting the initial downward movement. The net effect is here assumed to be negative.

Using (5) and (29), gross private expenditure can be written as

Substituting equations (8b) and (29′) in (27) yields

Equations (18), (29′) and (30) indicate that the net effect of a real exchange rate depreciation (a rise in z_t) on consumption of imported goods is, in general, ambiguous. On the one hand, it reduces spending on imports directly since their relative price rises. On the other, it raises the real money stock (since the domestic-currency value of the stock of foreign reserves increases), thereby reducing the domestic interest rate and stimulating total spending. In what follows, we will assume that the direct effect dominates, so that a depreciation of the real exchange rate reduces purchases of imported goods.

Finally, from the definition of the product wage in the export sector, we have

where the sign preceding the term in brackets on the right-hand side of the equation is negative if contracts are backward-looking, and positive if contracts are forward-looking.

Equations (4c), (4d), (9c), (18), (25a) or (25b), (28′), (30) and (31) describe the evolution of the economy along any perfect foresight equilibrium path. ^1/ In a more compact form, these equations can be written as, assuming a constant foreign interest rate and a constant devaluation rate equal to ε:

where $c_I\left(\right)\equiv \left(1-\delta \right)z_t^{-\delta }c\left({\lambda }_t,m_t\right)$, and with equation (26) determining residually lump-sum taxes.

Equations (32) can be further condensed into a dynamic system in four variables: the marginal utility of wealth, the real exchange rate, the product wage in the export sector, and total holdings of foreign bonds measured in foreign currency terms, $F_t=R_t+b_t^{*}$ (see Appendix II). With forward-looking contracts, the model has three jump variables (λ_t, z_t and ω_t) and one backward-looking variable (F_t), hence requiring three unstable roots. Given this condition, and since total holdings of foreign assets evolve continuously from their initial level F₀, the appropriate initial jump in the real exchange rate and the product wage following any exogenous shock will take place through a jump in the price of nontraded goods and nominal wages respectively, whereas the jump in the marginal value of wealth will occur through an adjustment in private expenditure. With backward-looking contracts, the model has one forward-looking variable, λ_t, and three backward-looking variables, z_t, F_t and ω_t, hence requiring one unstable (positive) root and three stable (negative) eigenvalues for the saddlepoint property to be satisfied. Given that holdings of foreign assets, the real exchange rate and the product wage evolve continuously from their initial levels F₀, z₀ and ω₀, the appropriate initial jump in the marginal value of wealth following an exogenous shock to the economy will also be obtained by a discrete adjustment in private consumption. Appendix II establishes the conditions under which the model is saddlepoint stable under alternative specifications of wage contracts. ^1/

IV. Steady-State Effects of Policy Shocks

In what follows the model developed in the previous sections is used to examine the macroeconomic effects of two policy measures that have figured prominently in stabilization programs implemented in developing countries, namely a reduction in government spending on home goods and a reduction in the nominal devaluation rate. Because of the highly complex nature of the short-run dynamics of the model described in the the previous sections under both backward- and forward-looking contracts, only the steady-state effects of these shocks will be examined. ^1/

In the steady state, ${\dot{\lambda }}_t={\dot{z}}_t={\dot{\omega }}_t={\dot{R}}_t={\dot{B}}_t^{*}=0$. Equation (32b) therefore implies that the after-tax real interest rate is equal to the rate of time preference:

where a ‘~’ is used to denote steady-state values. The market for nontraded goods must be in equilibrium in the steady state, implying from equations (11) and (32g) that

This condition implies, using equation (32d) with ż_t = 0:

From equations (24) and (32f), the rate of increase in home goods prices and the overall domestic inflation rate must be equal to the devaluation rate $\left({\tilde{\pi }}_N=\tilde{\pi }=\epsilon \right)$. From equation (10) or (32c), since equilibrium in the nontraded goods market implies that the mark-up rate is constant, the rate of growth of nominal wages must also be equal to the devaluation rate. Substituting equation (33a) and $\tilde{\pi }=\epsilon$ in (32a) yields

from which it can be inferred that the steady-state real stock of foreign bonds, measured in foreign currency terms, is invariant to domestic policy shocks other than a change in the tax rate on income (see Agénor, 1994).

Equations (32e) and (32g) imply

Equations (33a)--with $\tilde{\pi }=\epsilon$, and $\left(1-\iota \right)\tilde{i}$ replaced by $\mathrm{\Phi }\left(\tilde{\lambda },{\tilde{z}}^{\delta }\tilde{R}\right)$--and (33b)-(33e) can be solved simultaneously for the steady-state values of $\tilde{\lambda },\tilde{R},{\tilde{B}}^{*},\tilde{z}\mathrm{and}\tilde{\omega }$, from which the long-run effects of a reduction in the devaluation rate or in government spending on nontraded goods can be assessed. Tedious but straightforward calculations indicate that, with backward-looking contracts:

while with forward-looking contracts:

Consider first a reduction in public spending on home goods. The steady-state effects of this policy shock are the same, regardless of the nature of the expectational mechanism embedded in wage contracts: it lowers the marginal value of wealth (hich stimulates private consumption), reduces the product wage and raises output in the export sector while leading to a depreciation of the real exchange rate to maintain equilibrium in the nontraded goods market. The desired stock of foreign bonds (whose foreign currency value is independent of the policy shocks considered here, as indicated earlier) rises as a result of the fall in the relative price of domestic goods. In equilibrium, output of nontraded goods is equal to its capacity level, and is thus independent of changes in government expenditure. The movements in net foreign assets of the central bank is generally ambiguous. On the one hand, higher exports and the real exchange rate depreciation (which dampens demand for imported goods) have a positive effect on reserves. On the other hand, the reduction in the marginal value of wealth raises total consumption expenditure and thus the demand for imports. A sufficient condition for the net effect on reserves to be positive is that the net effect on consumption of imported goods be negative. Since, from equation (33a), the real after-tax interest rate remains constant (and equal to the rate of time preference), the nominal interest rate must rise in the same proportion as the inflation rate. But since the domestic inflation rate is not affected by the reduction in government spending (it depends only on the devaluation rate), the nominal interest rate must also remain unchanged $\left(d\tilde{i}/{\mathit{dg}}_N=0\right)$. ^1/ Thus, the “effective” price of consumption does not change, and private expenditure expands only as a result of the fall in the marginal utility of wealth. Finally, it can be noted that from equations (8) and (33c):