The effects of an appreciation of the deutsche mark are traced with the help of a computable general equilibrium model under alternative structural policy scenarios. In the first scenario, characterized by severe structural rigidities, the contractionary effects of exchange rate appreciation dominate the expansionary effects, so that gross domestic product and employment fall and the external surplus declines only slightly. In the alternative case of free movement of goods, services, and factors, the expansionary effects of the appreciation become more prominent as supply and demand respond much more readily to the relative price changes. [JEL 431]
When efforts to redress the international economic imbalances among major industrial countries began in 1985, the emphasis was on macroeconomic policies and exchange rate changes. With the room for maneuver in these policy areas diminishing and the adjustment being far from complete, however, the focus has recently shifted to structural policies. With regard to the Federal Republic of Germany in particular, the view has gained strength that trade liberalization as well as deregulation of goods, services, and labor markets would make an important contribution to the external adjustment of this economy by increasing its responsiveness to the exchange rate changes that have already taken place.
The present paper seeks to examine this hypothesis by investigating the effects of structural rigidities and protectionist practices on the adjustment process in Germany. The analysis is conducted in the form of an illustrative quantitative exercise in which the effects of an exogenous appreciation of the deutsche mark are examined under different structural policies. The results of this investigation indicate that structural policy action, supported by macroeconomic policies consistent with the nominal targets of the German authorities’ medium-term economic strategy, would indeed facilitate external adjustment in an environment of higher growth, lower unemployment, and lower inflation. In the following section, several protectionist practices and rigidities that could be obstacles to adjustment are identified. Section II outlines an analytical framework for a quantitative analysis of the effects of these policies and rigidities on the German economy, and Section III presents the results of the illustrative exercise. Section IV discusses possible costs of adjustment to more liberal policies, and some concluding observations are made in Section V.
Armington, Paul S., “The Geographic Pattern of Trade and the Effects of Price Changes,” Staff Papers, International Monetary Fund (Washington), Vol. 16 (July 1969), pp. 176–199.
Burda, M.C., and J.D. Sachs, “Institutional Aspects of High Unemployment in the Federal Republic of Germany,” NBER Working Paper 2241 (Cambridge, Massachusetts: National Bureau of Economic Research, May 1987).
Dixon, Peter B., and others, ORANI—A Multisectoral Model of the Australian Economy (Amsterdam and New York: North-Holland, 1982).
Guitián, Manuel, “The Effects of Changes in the Exchange Rate on Output, Prices and the Balance of Payments.” Journal of International Economics (Amsterdam), Vol. 6 (1976), pp. 65–74.
Lächler, U., “The Elasticity of Substitution between Imported and Domestically Produced Goods in Germany,” Weltwirtschaftliches Archiv (Kiel), Vol. 121 (No. 1, 1985), pp. 74–96.
Mr. Mayer, an economist in the Central European Division of the European Department of the Fund, is a graduate of the University of Konstanz and the University of Kiel in the Federal Republic of Germany.
Guitián (1976) showed that this is likely to he the case when the share of the nontraded-goods sector in total output is smaller than that of the traded-goods sector.
Growth of GNP is given by
There are several impediments to labor mobility, both on the demand and on the supply side. On the demand side, laws enacted for the protection of employees have over time increased the costs of layoffs for companies, with the result that employers have become reluctant to hire even when their business outlook is improving; often they prefer to invest with a view to increasing the productivity of the existing work force to meet higher demand. On the supply side, relatively generous unemployment benefits and a deeply rooted regionalism have tended to discourage laid-off workers from bearing the adjustment costs associated with a change to a new industry, region, or both. See Burda and Sachs (1987).
Among the service industries listed in Table 2, only telecommunications and transportation were allocated to the traded-goods sector, given the potential (telecommunications) or actual (transportation) role of these industries in the international trade in services.
The telecommunications and transportation industries that were classified as traded-goods industries accounted for about 12 percent of the value added of this sector.
In the manner of Armington (1969), it is assumed that domestically produced goods and imported goods are imperfect substitutes.
Note that only sector 1 (basic goods) uses land as a productive factor.
The German input-output table has a “government sector” that creates the goods used by government. This sector is contained in the nontraded-goods sector of the model.
The Armington (1969) assumption implies that goods are differentiated by source of production. Thus, German exporters face a downward-sloping foreign demand curve.
Implicit in this treatment of import supply is the assumption that the rest of the world produces goods for the German market that are not complete substitutes for goods shipped to other markets. In other words, the Armington (1969) assumption also holds for import supply.
The assumption of zero pure profits implies that there are no undistributed profits. Rents to productive factors, however, are not excluded.
Note that market clearing does not necessarily imply full employment of all factors. In fact, as outlined below, the model allows the fixing of factor prices at above full employment levels and the equilibrating of supply and demand at these prices.
In the following experiments it is assumed that the shares of (private and public) consumption and investment in domestic absorption remain unchanged.
Using the relationship between per capita GDP and w estimated by Lluch, Powell, and Williams (1977, p. 248).
The design of the model ensures that there is a unique solution provided that the matrix to be solved is not singular (see Dixon and others (1982)).
Real wages that are rigid and above full employment levels have been a common characteristic of most European countries during the 1980s.
In principle, the decline in the domestic price level elicited by the exchange rate appreciation will increase real financial household balances, which in turn will boost real consumption and contribute to a decline in the savings rate. Higher real consumer demand, together with a higher rate of return for capital, will then stimulate real investment. The role of monetary policy in this context is to support these effects by stabilizing nominal private absorption through monetary expansion in line with potential output growth and some acceptable and sustainable rate of price increases.
Although these assumptions are in accord with the key principles of the European Community Common Agricultural Policy and the German support scheme for coal mining, the implementation of these policies is in reality slightly different. For example, the authorities are likely to take into account, at least partially, the effects of an appreciation on costs and factor incomes in the respective sectors when they set prices there. Moreover, subsidies are given to two main industrial users of coal—the steel and electricity industry—to compensate them partially for the use of high-priced German coal. In the case of steel, the subsidies are borne by the federal budget, and in the case of electricity the costs of the subsidies are passed on to the consumers (Kohlepfennig). These arrangements may alleviate the direct effects of the coal support scheme on the respective industries, but they do not change the final effects on the German economy. In either case, relative prices are distorted, and aggregate production costs increase.
Protection for shipbuilding, which has been afforded largely in the form of subsidies, was not separately modeled. Instead, it was assumed that measures similar to those in the other protected industries were taken to reduce competition from imports.
This assumption, which again is only a crude approximation of reality, reflects the low degree of intersectoral wage differentiation (see Table 3) and the highly centralized organization of the German trade unions. This organization has contributed to the fast diffusion of wage increases from one industry to the other industries in the economy.
Note that the increase in real domestic absorption is not explicitly explained by the model. The result is, however, in line with conventional wisdom: real private consumption increases as a result of higher real income and real balance effects, elicited by the decline in the price level and the expansionary effects of a monetary policy that follows nominal potential GDP growth rather than actual growth: real investment increases because of accelerator effects and a higher return to capital; and real government expenditures increase as the authorities stick to their medium-term nominal expenditure targets.
The buoyancy of imports with respect to GNP is slightly greater than 2.0 and close to the historical average in Germany over the recent years. The (general equilibrium) elasticity of imports with respect to the real exchange rate is about 0.7 percent, a little higher than most econometric estimates of the partial real exchange rate elasticity of imports.
The elasticity of exports with respect to the real exchange rate is about 1.0. Econometric studies have usually arrived at a value a little smaller than this. Part of the discrepancy can be explained by the assumed absence of protectionist practices and structural rigidities under the baseline simulation, which contributes to higher trade elasticities in the economy. Indeed, in scenario 4, the export and import elasticities decline to 0.9 and 0.2, respectively.
Given the assumption of constant returns to scale, the percentage change in output equals the weighted average of the percentage changes of factor inputs plus any efficiency gains that may arise from a reallocation of factors among industries. In the case of Germany, there are only very small differences in the marginal returns to labor across industries, so that efficiency gains do not arise. Thus, the increase in employment is almost identical to the increase in output divided by the share of labor in total value added (0.63).
Indirect taxes will remain largely unaffected because they are related to nominal domestic absorption, which remains unchanged.
This implies a largely neutral fiscal policy stance, since the decline in total government revenue is smaller than that of nominal GDP and the ratio of expenditures to potential nominal GDP remains broadly unchanged.
Like the basic-goods sector, the protected-goods sector has a higher price elasticity of imports and exports, and a higher substitution elasticity between imported and domestically produced goods, than does the traded-goods sector. The export orientation of the protected-goods sector (measured as exports in percent of output) is only a little smaller than that of the traded-goods sector, but more than twice as high as that of the basic-goods sector. Also, its import penetration ratio is only slightly smaller than that of the basic-goods sector but substantially larger than that of the traded-goods sector.
In reality, part of the increase in production would, of course, lead to stock accumulation and therefore to a smaller rise in exports than projected in this illustrative exercise.