Consumer Problem

The economy is inhabited by a representative consumer, who maximizes lifetime utility derived from the consumption of tradable and nontradable goods:

subject to

where subscripts T and N refer to the tradable and nontradable goods sectors, and subscript t refers to time. Choice variables are: c_Tt and c_Nt, the consumption of the tradable and nontradable goods in period t; k_t+1, the domestic capital stock at the beginning of period t +1; b_t+1, the net foreign asset position, denominated in tradables; $l_t^F$, the amount of labor that is allocated to the rest of the world in period t. β is the subjective discount factor with 0 < β < 1.

The per-period budget constraint is expressed in terms of tradable goods. The total labor endowment is normalized to unity. Notation is as follows: p_Nt is the relative price of the nontradable good, and $p_N^{*}$ is its price in the rest of the world, which is a constant since the rest of the world is assumed to be in a steady state and the model economy is small; i_Tt (k_Tt+1, k_Tt) and i_Nt (k_Nt+1, k_Nt) represent investment in the capital stock of the tradable and nontradable sectors; q_t is the relative price of investment; $\Gamma (l_t^F,l_{t-1}^F)$ is an adjustment cost term associated with changes in labor employed abroad; r is the risk free return on net foreign assets; w_t is the wage at which an endowment of labor is supplied in the domestic market, while w^* is the wage rate in the rest of the world; h_t k_t sis income from renting capital at the relative price h_t to producers in the tradable and nontradable sectors; q_t is the price at which the consumer acquires capital for period t+1 (the transaction takes place at the end of period t), whereas h_t is the price at which the consumer rents capital in period t to firms.

In each period the consumer ensures that labor income, rental income, and the proceeds from lending (principal plus interest) exceed the consumption expenditure of tradable and nontradable goods, investment outlays for the tradable and nontradable sector, any lending that is conducted, and the costs associated with the change in labor located in the rest of the world. Note that the investment decision takes into account the existing capital stocks in the tradable and nontradable sectors ($k_{Tt}^i$ and $k_{Nt}^i$), which the consumer takes as given from the optimization problem of the producer. It is further assumed that b₁ is given. We rule out Ponzi schemes by assuming that b_t+1 +q_t+1k_t+1, in any period cannot be smaller than −A, for A sufficiently large.

International labor mobility considerations enter the consumer problem in the consumer’s choice of the amount of labor that is allocated abroad in each period, $l_t^F$. Several terms in the per-period budget constraint are directly affected by the labor allocation decision. First, nontradable goods are consumed at home and abroad, proportionally to the period’s labor allocation, at different relative prices, p_Nt and $p_N^{*}$. For tradable goods, foreign consumption does not alter the budget constraint, since the price of tradable goods is the same at home and abroad. Second, any change in foreign labor allocation incurs adjustment costs, which derive from the movement of labor across borders (e.g., transportation costs). This cost term is assumed to satisfy all the standard adjustment costs properties (i.e., convex and absent in steady state). Third, on the income side, labor income reflects different wage rates earned at home and abroad.

Producer Problems

Aggregate Resource Constraints

The aggregate resource constraints for the tradable and nontradable sector are as follows. In addition to being consumed, the tradable and the nontradable goods can be used as inputs into the investment sector. The economy’s resource constraint for nontradable goods is:

where the consumption of domestic nontradables both as final and intermediate goods cannot exceed its domestic production.

The resource constraint for tradable goods incorporates the possibility of trading with the rest of the world as well as the possibility of having labor move across borders:

Because of international labor mobility, the trade balance is defined as

Here the term b_t+1−b_t (1+r) captures changes in the net foreign asset position and capital income; $-l_t^F(w^{*}-p_t^{*}{c}_{Nt}-c_{Tt})$ represents the part of foreign labor earning that is left over after the consumption of tradable and nontradable goods abroad. Such earnings are then sent back home as labor income and, for a given current account position, allow the model economy to run a smaller trade balance.¹¹ $\Gamma (l_t^F,l_{t-1}^F)$ are adjustment costs for foreign labor, assumed to be incurred in terms of tradable goods. Whether this term is part of the trade balance depends on the destination of such payments—the domestic economy or the rest of the world. However, regardless of these considerations, the size of these payments as a share of output is negligible in the parameterized model, and therefore do not affect the trade balance in any significant way.

For production factors the following constraints are satisfied:

which are, respectively, an aggregation constraint needed to ensure that the capital stock level derived in the consumer problem equals the capital stock levels used in the tradable and nontradable sectors as derived in the producer problems, and a resource constraint applicable in the labor market, ensuring that labor used in the tradable, nontradable sectors and abroad adds up to the total labor endowment.

Capital accumulation occurs as follows. The investment good augments the capital stock in the subsequent period, which gives the following law of motion for capital in the tradable sector (the law of motion is analogous in the nontradable sector):

where δ is the depreciation rate with 0 <δ < 1 and the following resource condition is satisfied:

Finally, the model allows for different specifications of interest rate determination. If the economy is closed to cross-border resource flows in period t, there can be no foreign borrowing or lending, b_t+1=b_t, and the return on investment is endogenously determined in the model. If the economy is open, the interest rate is equal to an exogenously given international rate, r, and b_t+1 is endogenously determined.

Functional Forms and Parameterization

To solve the model, we need to make some assumptions about the functional forms and parameter values. We assume that consumer utility is given by:

where a unitary elasticity of substitution between tradable and nontradable goods is imposed. ε is the weight of tradable goods in consumption expenditures and ρ captures the intertemporal elasticity of substitution in consumption.

Investment goods are produced from tradable and nontradable goods as follows:

where γ is the weight of tradable goods in investment expenditures. Following Bems (2008), we impose a unitary elasticity of substitution between the two goods. Also, we normalize

The production function for sector j={T,N} is assumed to take the following form:

where apart from producing output with the standard Cobb-Douglas production function with capital and labor as production factors, producers in each sector incur costs every time the stock of labor is changed. We assume that such costs are quadratic with level parameter λ capturing the size labor adjustment costs.

Following Lucas and Prescott (1971), we introduce sectoral investment adjustment costs:

where η∈ (0,1] is the investment adjustment cost parameter and η=1 represents the case of no adjustment costs. The functional form satisfies Φ(δ) =δ, Φ'(δ)=1 and Φ" (δ)=0. Thus, similar to labor, there are no investment adjustment costs in the steady state.

Adjustment costs incurred by cross-sectoral labor movements are specified as:

Consumers incur quadratic costs in periods when the allocation of foreign labor is changed. The size of such costs is determined by the cost level parameter, ζ. Recall that the total labor endowment in the model is normalized to unity.

Parameterizing the model’s steady state, we set one period equal to one year. The initial net foreign asset position is set as b₀ =0, which captures the closed-economy steady nature of the initial steady state. The intertemporal elasticity of substitution in consumption is set at 1/ρ= 0.5, as in the real business cycle literature. The discount factor is set at β = 0.96. The expenditure weights for tradables in consumption and investment, ε and γ, are based on input-output table data for new member state countries, and take values of 0.34 and 0.44, respectively. Note that consumption is more intensive in nontradables than investment. The income share for capital, α, is set to 0.33 and the same for both sectors (which is in line with input-output data). Next, given values of β and α, δ is set to match the investment-output ratio, equal to 0.21.

Without loss of generality, for the rest of the world the ratio of steady state productivity levels in the two sectors, $A_T^{*}/A_N^{*}$, is normalized to unity, and level wise set at $A_T^{*}=A_N^{*}=1.10$. As a result, the relative price in the rest of the world is also unity, $p_N^{*}=1$. In the relatively poor model economy, productivity levels in the initial steady state are below those observed in the rest of the world. Finally, to facilitate comparison between the model with and without cross-border labor mobility, the fraction of labor abroad in the initial steady state is set at $l_0^F=0$. The choice of all parameter values is summarized in Table 3.

Table 3:

Parameter Values and Initial Conditions

Table 3:

Parameter Values and Initial Conditions

Parameter	Value
1/ρ	0.50
β	0.96
ε	0.34
γ	0.44
α	0.33
δ	0.073
$A_T^{*}=A_N^{*}$	1.10
$l_0^F$	0
b 0	0

View Table

Table 3:

Parameter Values and Initial Conditions

Parameter	Value
1/ρ	0.50
β	0.96
ε	0.34
γ	0.44
α	0.33
δ	0.073
$A_T^{*}=A_N^{*}$	1.10
$l_0^F$	0
b 0	0

To further clarify the list of the initial conditions in Table 3, note that the model cannot be used to solve for the optimal steady state level of the foreign labor. Instead, the steady state is defined for a given foreign labor share. This feature of the model’s steady state is reminiscent of the treatment of the net foreign asset position in the standard small open economy model, including the one considered in this paper. As a result, initial values for both initial net foreign assets and foreign labor need to be specified.

Case 1: Impact of Cross-Border Labor Mobility on Convergence

We now first discuss the setup of the model simulations that allow for the identification of the effect of international labor mobility on the convergence dynamics. Next, we will present simulation results and discuss the various forces at work.

To compare the model economy with and without cross-border labor mobility, both specifications need to start in the same initial steady state and face identical productivity shocks. When compared to the rest of the world, the model economy starts out in a steady state with lower productivity levels in both sectors and is closed to cross-border labor movements. The shock in the model is defined as news about a gradual bridging of the productivity gap with the rest of the world and, in case of cross-border labor mobility, also as the opening of labor markets to cross-border flows.

The level difference in productivity is set so as to allow for productivity convergence in each sector as well as the Balassa-Samuelson effect. The sectoral productivity in the initial steady state (and the subsequent productivity shock) is defined in the two sectors as:

where T is a sufficiently large number, ω = 0.5, g_T = 0.05, g_N = 0.01 and $A_{j,T}=A_j^{*}$ for j= {T,N}. The initial steady state values are denoted by A_j1 and, for the parameters used, correspond to levels of 9 and 2 percent, respectively, below tradable and nontradable sector values in the rest of the world. Notice that with the above specified evolution of productivity levels, the relative price of nontradables in the initial steady state is below the relative price in the rest of the world. This feature of the parameterization is a result of the assumed presence of the Balassa-Samuelson effect in the convergence process. The specified rule for sectoral productivity growth ensures that productivity levels eventually converge exactly to the ones observed in the rest of the world.

To simulate the model, we also need to specify parameters governing adjustment costs for sectoral investment, η, and changes in the domestic and foreign labor, λ and ζ. These parameters do not affect the initial steady state, but matter for the transitional dynamics and the final steady state.

• Transitional dynamics of the model are of interest only when the economy faces nonzero adjustment costs. Without such costs, the new steady state is reached already after one period of transition (see e.g., Obstfeld and Rogoff, 1996). Furthermore, when cross-border labor flows are allowed, the optimal solution is for all labor to immediately leave the economy, so as to take advantage of the higher returns abroad.

• With non-zero adjustment costs this is no longer the case, as the transition takes more than one period. Labor outflows in this case are more gradual, and they will stop or reverse by the time productivity convergence is completed. Thus, the model simulation comparisons require that for a given productivity shock, factor adjustment costs are sufficiently large. As will be evident from the simulation results below, quantitatively, even economically insignificant adjustment costs lead to well-defined model dynamics for large initial productivity shocks.

In view of these considerations, in the first set of simulations we switch off the factor adjustment costs to investment and cross-border labor flows, i.e., η= 1 and ζ= 0. Domestic sectoral labor adjustment costs are set at λ =2.

Simulation results of this parameterization are presented in Figure 3, where the solid lines represent the standard model where cross-border labor movements are not allowed. The dashed line shows the dynamics from the model with endogenous cross-border labor flows, as developed in this paper. The figure depicts the sectoral productivity shocks (the same for both model specifications) as well as the optimal response of consumption, output, foreign labor, the external sector, the relative price of nontradables, and the real wage to the productivity shocks. Productivity, output and consumption levels are all expressed relative to their initial steady state values; prices are expressed relative to the final steady state; external sector variables are measured as a percentage of output; and the cross-border labor allocation is expressed as a percentage of the total labor endowment.

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Simulations with Minimal Factor Adjustment Costs

Citation: IMF Working Papers 2008, 264; 10.5089/9781451871227.001.A001

Source: Authors’ calculations

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In the case of no cross-border labor mobility, the model dynamics exhibit the two stages of convergence as discussed in the previous section. After the productivity shock, consumption smoothing considerations dictate the transitional dynamics to a new steady state with higher consumption levels. To speed up the increase in consumption, the model economy initially borrows resources from the rest of the world, and specializes domestically in the production of nontradables (expansion stage). Subsequently, as the level of foreign debt grows, the economy shifts back towards the production of tradables, which are used to service the foreign debt (reorientation stage).¹²

How does cross-border labor mobility affect the transition? The answer can be derived by comparing the solid and dashed lines in Figure 3. Cross-border labor mobility adds the following new first order conditions to the system of non-linear equations that determine transition dynamics in the model:

where to simplify the expression we have applied ζ=0 eliminate the adjustment cost terms.

After the productivity shock and removal of cross-border labor flow restrictions, the representative consumer in the model faces a real wage gap,¹³ i.e.,

Labor will be reallocated to the rest of the world until this gap is closed. These considerations set in action the following dynamics: ceteris paribus, labor outflows increase the marginal product of labor, narrowing the wage gap. At the same time, the reduction in the domestic labor force lowers the marginal product of capital, resulting in less investment or even disinvestment. This in turn lowers the marginal product of labor, and induces further labor outflows. As discussed earlier, without adjustment costs, these dynamics would lead to an instant reallocation of all labor (and capital) to the rest of the world. However, in the presence of adjustment costs to factors of production (in this case sectoral labor adjustment costs) the outflow is more gradual and stops once the wage-price gap is closed.

The dynamics are further affected by changes in the relative price of nontradables, which is initially lower than in the rest of the world, and the consumption of nontradables. Both variables increase during the first period of transition, making their overall contribution to the real wage gap indeterminate. In Figure 3, the relative price during transition remains below the rest of the world level, while consumption overshoots the steady state level. To satisfy the first order condition, the wage also overshoots the level in the rest of the world.

As can be expected, access to a higher foreign wage speeds up the convergence process in the model. Intuitively, by reallocating abroad, a fraction of the labor provided by the representative consumer can immediately command higher compensation due to the higher foreign productivity levels. This increases both income and consumption, but aggregate output growth at home will be lower as the size of the local labor force shrinks.

With cross-border labor mobility, the two stages of the convergence process are less pronounced. As labor reallocates abroad, so does part of the domestic demand for tradable and nontradable goods. The lower demand for nontradables alleviates the main bottleneck in the convergence process. Consequently, the relative price of nontradables in equilibrium needs to increase by less. Concomitantly, the lower demand for tradables results in smaller external sector imbalances and a lower level of foreign debt. The only exception to this observation is the wage rate in the domestic economy, which is further increased by the cross-border mobility of labor.

Interestingly, the transitional dynamics in the model can exhibit partial return migration. In Figure 3, around 5 percent of the labor force reallocates to the rest of the world during the initial 5 years of transition. In the subsequent decade some of the labor returns, with foreign labor stabilized ultimately at 2 percent of the total labor endowment. The size of return flows is determined by a complex interplay of expected productivity increases and adjustment costs. Because of adjustment costs to factors of production, in initial periods the “real wage”, i.e., wage adjusted for price level differences, can overshoot its level in the rest of the world and subsequently induce return flows.

Case 2: Impact When Adjustment Costs are Large

The transitional dynamics in Figure 3 exhibit uncomfortable “over-shooting” dynamics in several variables. In particular, the wage in the first transition period exceeds that of the final steady state and consumption peaks in the first period of transition. This subsection considers an alternative simulation with larger factor adjustment costs and a more persistent productivity increase. It is argued that the absence of adjustment costs and lack of persistence in productivity growth drive the overshooting dynamics.

For the simulations of this subsection, adjustment costs for sectoral investment are set at η= 0.9, which is a standard value in the literature. The level parameter for adjustment costs in cross-border labor flows is set at ζ= 100. The resulting adjustment costs during transition are economically insignificant, peaking at 0.05 percent of consumer income in the initial period of transition. Domestic sectoral labor adjustment costs are kept at λ = 2, unchanged from the previous parameterization. To increase the persistence of productivity growth, we set ω = 0.8, g _T=0.06 and g_N =0.03.

Figure 4 summarizes the simulation results from this parameterization. As before, outcomes from the model with (dashed line) and without (solid line) cross-border labor mobility are compared. In line with the parameterization, the productivity shock is considerably more persistent, leading in the final steady state to a 33-percent increase in the level of productivity in the tradable sector and a 15-percent increase in the nontradable sector.

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Simulations with Larger Adjustment Costs

Citation: IMF Working Papers 2008, 264; 10.5089/9781451871227.001.A001

Source: Authors’ calculations

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Despite the added persistence and adjustment costs, the qualitative story behind the effects of cross-border labor mobility on transitional dynamics is the same as in Figure 3: the convergence process is sped up and the two stages of convergence are less pronounced, except in the case of the domestic wage rate.

Quantitatively, adjustment costs and persistence in productivity eliminate the initial overshooting dynamics in consumption and the wage rate. If a larger role for Balassa-Samuelson effect in productivity convergence was assumed, the relative price of nontradable goods in the first period would also remain below the final steady state level. Since in the initial period the trade deficit exceeds the current account deficit¹⁴, this model simulation exhibits sizable (around 1.5 percent of output) wage remittance flows into the model economy.

Finally, notice that the results in Figure 4 feature considerably larger labor outflows and no return migration. Larger outflows result from the wider initial productivity gap, which increases the benefits from reallocating labor to the rest of the world. The optimal transition path exhibits small amounts of return migration from period 30 onwards (not included in the figure), but the observed return flows are economically insignificant. The eventual size of the foreign labor remains at 16 percent of the total labor endowment.

Case 3: Pace of Productivity Convergence and the Boom and Bust Cycle

Next we apply the model to examine two further questions concerning optimal cross-border labor flows during the income convergence process. First, for a given productivity gap, how does the speed of productivity convergence affect the size of labor outflows? Second, what is the impact of “overly optimistic” expectations for productivity convergence on labor outflows?

To answer the first question we consider two alternative paths of “fast convergence” and “slow convergence”. In both cases, identical productivity gaps between the model economy and the rest of the world are bridged. In the case of fast convergence, productivity converges quickly and smoothly. In the slow convergence case, productivity convergence is interrupted for some years. We assume that the initial 5 years of convergence are followed by 5 years of zero productivity growth, with productivity convergence resuming subsequently. As a result, in the case of slow convergence, catch-up in productivity takes exactly 5 years longer.

The optimal cross-border labor flows for the two scenarios are presented in Figure 5, where the dashed and solid lines represent respectively the cases of slow and fast convergence. The results suggest that labor outflows decrease with the speed of convergence. Intuitively, faster productivity convergence leads to smaller wage gaps. The closing of the wage gaps can then be achieved with a smaller reallocation of labor to the rest of the world. Importantly, not only the difference in productivity levels initially matters (which happens to be zero in this particular example), but also the difference in all subsequent periods of transition.

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Response of Cross-Border Labor Flows to Selected Convergence Scenarios

Citation: IMF Working Papers 2008, 264; 10.5089/9781451871227.001.A001

Source: Authors’ calculations

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The second question concerns the effect of “overly optimistic” expectations on the outflow of labor. To answer this question, consider a model simulation with two sequential shocks. Initially, agents believe that the economy is on a track of “fast convergence”. They hold this belief with full certainty. However, in period 5, new information about the productivity convergence process is revealed as follows: productivity growth will be zero for the next 5 periods and subsequently the initial convergence process will resume. What effect does the second shock have on optimal cross-border labor flows?

The model solution for this case is shown in Figure 5. After the second productivity shock in period 5, the optimal path for labor outflows diverges from the case of “fact convergence”. The new path for productivity implies larger wage gaps than initially expected. To bridge these larger wage gaps, a higher proportion of the total labor endowment is allocated to the rest of the world. These model results are in line with the view that an unexpected slowdown in the convergence process can generate new waves of labor outflows.

Interestingly, the model results suggest that overall labor outflows are substantially smaller in the case of a boom-bust cycle than in the case of a “slow convergence”. Consumers’ welfare is higher when “slow convergence” is initially correctly anticipated and labor can be allocated to the rest of the world from the outset.

Symptoms of Overheating…

During the early stages of transition, labor outflows occurred in the context of large unemployment and underemployment figures. Later on, domestic labor markets have experienced a tightening, driving up real wages (Figure 6), although this started to taper off somewhat more recently. Job vacancy rates evolved similarly (Figure 7), although in Estonia and Latvia they have started to fall recently. Shortages have emerged in segments of the labor market (e.g. construction and services), where labor demand was buoyant. With labor markets tighter, incremental moves in the supply of labor due to cross-border mobility have as a result become more easily reflected in wages.

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New Member States: Real Wage Developments, 2004-2008:Q1

(percent)

Citation: IMF Working Papers 2008, 264; 10.5089/9781451871227.001.A001

Sources: Eurostat; and IMF staff calculations.Notes: Average year-on-year quarterly growth rates, deflated by the consumer price index.

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New Member States: Job Vacancy Rates, 2005-07

(percent)

Citation: IMF Working Papers 2008, 264; 10.5089/9781451871227.001.A001

Sources: Eurostat; and IMF staff calculations.Notes: The job vacancy rate is defined as the ratio of total posts that are vacant to the number of occupied posts plus the number of job vacancies.

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Associated with labor outflows are the inflows of remittances. These support domestic economic activities, and, insofar as these activities push up the demand for domestic products, price and wage inflation could ensue. In addition to supporting household and family consumption, remittances may increasingly take on an investment character. The monies remitted by cross-border workers may be invested in domestic equity and real estate markets, thus amplifying existing appreciation pressures on these asset prices and feeding back into overall demand through wealth effects.

… Or Business As Usual?

Before assessing labor mobility’s role in overheating, how important has labor been relative to capital in the convergence process? It seems that, for most countries, the combination of anticipated productivity growth and the desire to smooth consumption have been a more powerful driving force than labor mobility.¹⁵ This is also apparent in the fact that, even if labor has flown out, capital has continued to flow in—which would not have been the case had net labor outflows been the dominant factor.¹⁶ So, if labor plays a more limited role than capital in the convergence process, one can safely conjecture that the role of labor in producing overheating is also more limited.

The role played by labor mobility, and its contribution to wage inflation and demand support (e.g. through remittances), need not be seen as causing overheating per se:

• A degree of wage inflation in domestic labor markets is a natural and optimal feature of convergence when labor is crossing borders.¹⁷

• Remittances allow households to access a wider set of consumption and investment choices, and are therefore a crucial channel through which cross-border labor mobility translates into welfare benefits.¹⁸

• Labor mobility may dampen the oscillations observed in the domestic economy. As labor flows out, some of the demand for nontradable goods is exported, thereby alleviating pressure on domestic resource constraints. As a result, the nontradable price boom and current account deterioration are both smaller.

Labor Mobility’s Cushioning Role

As shown by model simulations (see Figure 5 and accompanying discussion), labor mobility responds to overheating pressures: the outflow of labor moderates as the economy overheats, thereby diminishing labor’s effect on wage inflation. Labor mobility would also respond in the case of a significant cooling or “bust” in the boom-and-bust cycle. Whereas most countries have continued to register strong growth, the economic conditions in some countries, particularly those that had experienced overheating pressures previously, have started to turn around or have already done so. With labor markets open internationally, the concern is that the downturn produces additional outward flows of labor, as well as a reduced inflow of labor from abroad (including a reduced incentive for return inflows). The concern is particularly valid when the wage gap with destination countries is insufficiently closed.

The magnitude of the labor outflow following a downturn also depends, of course, on whether the downturn is similarly being felt in recipient economies. Indeed, if conditions deteriorate simultaneously in recipient and sending countries, the threat of additional labor outflows may be diminished. Also, region-specific shocks may induce both inward and outward migration. For example, a sector-specific shock in one region may induce an inflow of high-skilled workers from other regions, while producing an outflow of low-skilled workers.

Demand-Management Policies

Against this background, what are the implications for demand-management policies?

• With respect to episodes of overheating, the key policy implication is to address the source of overheating directly, taking into account that much of the wage pressures caused by labor mobility reflect natural convergence and not overheating. Attempting to limit labor mobility directly or to offset the resulting upward pressure on wages through demand management policies may hurt the overall economy’s convergence process and, therefore, individual and social welfare.

• At the same time, from a demand-management perspective, overheating may pose a number of secondary challenges, and the key will be to address these while preserving the benefits of labor mobility. For example, as noted, wage inflation may be a natural consequence of labor mobility. While these inflationary consequences are optimal, the policymaker will need to fine-tune demand management policies to ensure that wage pressures do not set off a self-feeding wage-price spiral.

• Policymakers will also need to keep the second-round impact in check to ensure that wage growth does not erode competitiveness. Even where local labor market characteristics, such as low degrees of unionization and high internal labor market flexibility, would suggest that wage growth can be kept in line with productivity growth, the threat of emigration limits the scope for doing so. In designing their policy response, policymakers will need to carefully monitor wage developments and walk a fine line between preserving competitiveness and allowing wages to rise naturally in line with what is optimal.

Mobilizing Labor Supply and Employment

Most NMS have experienced a significant improvement in labor market outcomes. Convergence led to a boost in the rate of job creation (Figure 8). As a result, average employment rates for the NMS rose by almost 5 percentage points, although the improvement varied significantly across countries. Similarly, unemployment indicators improved (Figure 9), falling from about 12 percent during the early 2000s to 7 percent in the past few years. Long-term unemployment rates also improved in many countries.

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New Member States: Employment Rate, 2000-07

(percent)

Citation: IMF Working Papers 2008, 264; 10.5089/9781451871227.001.A001

Sources: Eurostat; and IMF staff calculationsNotes: Values for Czech Republic and Romania are forecasts

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New Member States: Unemployment Rate, 2000-08

(percent)

Citation: IMF Working Papers 2008, 264; 10.5089/9781451871227.001.A001

Sources: Eurostat; and IMF staff calculationsNotes: Harmonized monthly unemployment rates averaged over periods indicated. Romania’s latest observation is March 2008.

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Notwithstanding these improvements, there is further scope to mobilize and better utilize labor resources in most NMS. While the average employment rate has improved in most countries, it remains in all countries below the Lisbon target of 70 percent. The average employment rate in 2007 stood at 63 percent, with some countries (Poland, Hungary, and Romania) experiencing rates below 60 percent. Also, unemployment rates remain high in several (notably the Slovak Republic and Poland, but also Bulgaria and Hungary).

Raising labor market participation rates will help ease pressures on the labor force arising from natural demographic reasons and net migration, both of which reduce the working-age population. As argued by Kaczmarczyk and Okolski (2008), changes in labor market participation may play a bigger role than purely demographic changes through natural population growth and net migration. It is essential for the NMS to improve participation rates so that they can successfully meet the challenges they will face.

A number of factors may complicate the mobilization of labor supply and the increase in employment rates:

• Overheating forces may have eroded the competitiveness of tradable industries, causing them to close down; if reinstalling industries is costly, completing the reorientation stage will become more difficult.

• Reorientation stage challenges are also more difficult to meet if the labor supply is limited and the skill profile of the workforce has deteriorated through the allocation of resources to the nontradable sector.

• The foreign debt will need to be serviced with a smaller labor support (assuming that much of the foreign debt remains local while labor migrates).

The process of income convergence is accelerated if policymakers stimulate labor force participation and employment rates. Greater labor market participation and lower structural unemployment could be achieved through better-targeted active labor market policies, less rigid regulations regarding hiring and dismissals, and an improved design of the tax benefits system.

Reducing Labor Market Mismatches

In a number of countries, labor outflows of the young and relatively low skilled have been particularly pronounced. This phenomenon has lowered the rate of wage dispersion across education levels. In Estonia, for example, net wages for those with tertiary education were 93 percent higher in 1997 than for those with only primary education; by 2006, this premium had fallen to 32 percent.¹⁹

In countries where mismatches have arisen due to changes in the composition of gross outflows and inflows, these mismatches will need to be addressed. Similar mismatches may arise from the aging of the populations in many countries. These problems complicate the reorientation of the economy to a high-value-added and competitive export sector.

To offset mismatches, further consideration should be given to relaxing immigration policies, so as to allow larger inflows from non-EU emerging economies.²⁰ In addition, countries could invest in return migration to attract back those emigrants who during their employment abroad have gained valuable skills. Some countries have, for example, launched initiatives to induce overseas nationals to “return migrate” to reduce mismatches domestically.²¹ Policymakers could also consider investing further in education, including tertiary education.