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Beggar Or Prosper-Thy- Neighbour? ILO Research Paper No. 11 Beggar or prosper-thy-neighbour? The international spillovers of labour cost Matthieu Charpe Stefan Kühn July 2015 International Labour Office Copyright © International Labour Office 2015 First published 2015 Publications of the International Labour Office enjoy copyright under Protocol 2 of the Universal Copyright Convention. Nevertheless, short excerpts from them may be reproduced without authorization, on condition that the source is indicated. For rights of reproduction or translation, application should be made to ILO Publications (Rights and Permissions), International Labour Office, CH - 1211 Geneva 22 (Switzerland) or by email: [email protected]. The International Labour Office welcomes such applications. Libraries, institutions and other users registered with reproduction rights organisations may make copies in accordance with the licences issued to them for this purpose. Visit http:/ifrro.org to find the reproduction rights organisation in your country. ISSN 2306-0875 (web pdf) The designations employed in ILO publications, which are in conformity with United Nations practice, and the presentation of material therein do not imply the expression of any opinion whatsoever on the part of the International Labour Office concerning the legal status of any country, area or territory or of its authorities, or concerning the delimitation of its frontiers. The responsibility for opinions expressed in signed articles, studies and other contributions rests solely with their authors, and publication does not constitute an endorsement by the International Labour Office of the opinions expressed in them. Reference to names of firms and commercial products and processes does not imply their endorsement by the International Labour Office, and any failure to mention a particular firm, commercial product or process is not a sign of disapproval. ILO publication and electronic products can be obtained through major booksellers or ILO local offices in many countries, or direct from ILO Publications, International Labour Office, P.O. Box 6, CH-1211 Geneva 22 (Switzerland). Catalogues or lists of new publications are available free of charge from the above address, or by email: [email protected]. Visit our site: http://www.ilo.org/pubins Table of contents Acknowledgements Abstract 1 Introduction ................................................................................................................................... 1 2 Model description........................................................................................................................... 3 2.1 Labour market ....................................................................................................................... 3 2.2 Households ............................................................................................................................. 3 2.3 Firms...................................................................................................................................... 4 2.4 Labour market equilibrium .................................................................................................... 5 2.5 Resource constraint and policy .............................................................................................. 6 3 Calibration ..................................................................................................................................... 6 4 Analytical investigation.................................................................................................................. 8 4.1 Discussion of model mechanics .............................................................................................. 10 4.2 The demand switching effect ................................................................................................. 12 4.3 Sensitivity discussion ............................................................................................................. 13 5 Simulation ...................................................................................................................................... 14 5.1 Recap of the main transmission channels .............................................................................. 15 5.2 Rule of thumb households...................................................................................................... 15 5.3 New-Keynesian model: Beggar-thy-neighbour without rule-of-thumb households? ............... 17 5.4 Sensitivity analysis of the model with rule-of-thumb: External sector .................................. 19 5.5 Sensitivity analysis of the model with rule-of-thumb: Habits and Calvo prices .................... 21 5.6 Sensitivity analysis of the model with rule-of-thumb: Monetary policy ................................ 22 5.7 Sensitivity analysis of the model with rule-of-thumb: Labour market variables.................... 25 5.8 Zero lower bound in monetary policy .................................................................................... 27 5.9 Sensitivity analysis of the model with rule-of-thumb: Exchange rate regime ........................ 29 6 Conclusion...................................................................................................................................... 30 References............................................................................................................................................ 31 Appendix: Derivation of mathematical solution.................................................................................. 33 Acknowledgements This paper benefited from the comments of two anonymous referees, of Nicolas Coeurdacier, Willi Semmler, Thepthida Sopraseuth and Etienne Wasmer as well as the comments of the participants of the LIEPP seminar in Sciences Po, the T2M conference in Lausanne, the seminar of the Graduate Institute of International Studies in Geneva and the 4th conference on Recent Developments in Macroeconomics in Mannheim. Abstract This paper presents a two-country DSGE model with frictions in the labour market and constrained households to assess the international spillovers of a decline in labour costs. Lower labour costs have ambiguous effects on domestic and foreign output in the presence of a transmission channel linking real wages with consumption and savings decisions of households. This transmission channel takes place via credit constrained households. The main result is that lowering labour costs in the home country has a positive impact on the domestic economy as the competitiveness effect dominates the lower labour income/lower domestic consumption effect. However, lower labour costs may produce a significant beggar-thy-neighbour effect in the open economy case for a large set of parameters. The relative strength of the beggar-thy-neighbour effect depends in particular on the relative size of the two households’ populations, on home bias and the substitution between home and foreign goods, as well as on the reaction of monetary policy to inflation. Lastly, lowering labour costs in the home country is detrimental to both the home country and the foreign country in the presence of a zero lower bound in the nominal interest rate. Keywords: real wage, search and matching, two country, zero lower bound JEL classification: E24; E32; E62 Beggar or prosper-thy-neighbour? The international spillovers of labour cost 1 1 Introduction Reducing labour costs in order to improve trade competitiveness is often seen by policy makers as a requirement for economic recovery in times of crisis. Political will to reduce labour costs becomes even more pressing when traditional counter-cyclical policies are less effective. In many high income countries for instance, fiscal policy is limited by the level of indebtedness and monetary policy is constrained by the zero lower bound. This may put social partners under pressure to accept a temporary decline in labour cost to maintain jobs. However, improved competitiveness at home may have adverse effects on trading partners. This paper assesses the impact of a temporary decline in real wage on the domestic economy as well as on its trading partners. After discussing the impact on the domestic economy, the paper evaluates whether a decline in labour costs in the domestic economy has a beggar-thy-neighbour effect or a prosper-thy- neighbour effect on the trading partner. A beggar(prosper)-thy-neighbour is defined as a decline(increase) in foreign output following the reduction in labour costs in the domestic economy.1 This assessment is conducted using a two-country New-Keynesian DSGE model with frictions in the labour market.2 Lower labour costs are proxied by a temporary decline in the bargaining power of workers3, which leads to a decline in real wages.4 The distinctive feature of this New-Keynesian model is to highlight a direct link between labour costs and aggregate demand via the presence of constrained households. In a closed economy New-Keynesian DSGE model with labour friction,5 a fall in the real wage has positive effects on both output and employment. A decline in real wage raises the surplus of firms from an additional match, creating an incentive for firms to post vacancies. This leads to higher employment and output, which are further enhanced by monetary policy as prices decline with labour costs. In a two-country New-Keynesian DSGE model, the impact of lower labour costs on trading partners depends on the relative size of the income effect and the substitution
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