Cyclical wage movements in emerging markets compared to developed economies: The role of interest rates

Abstract

This paper documents that, at the aggregate level, (i) real wages are positively correlated with output and, on average, lag output by about one quarter in emerging markets, while there are no systematic patterns in developed economies, (ii) real wage volatility (relative to output volatility) is about twice as high in emerging markets compared with developed economies, and (iii) real wage volatility, as a ratio of output volatility, decreases with the level of financial development across countries. I then present a model of contractual arrangements between workers and employers in a small open economy that helps explain this contrast. Only employers have access to financial and capital markets in the model, but they need to borrow working capital to pay for labor costs before production is carried out. The idea is that countercyclical interest rates and less developed financial markets in emerging markets make it less optimal for employers to provide workers with relatively stable wages, leading to more volatile and procyclical wages. This is further demonstrated by calibrating the model using data from Mexico and Canada.

Simple Models to Understand and Teach Business Cycle Macroeconomics for Emerging Market and Developing Economies

“…This gure also illustrates that real wage volatility is higher in emerging markets than in developed economies, as reported by Li (2011). If the default premium is virtually insensitive to TFP changes in a developed economy, then the eect of future TFP on the interest rate should be low or nil and, therefore, we should observe a small expansion, if any, of the labor demand.…”

Sovereign defaults and banking crises

“…18 The data for the correlation between employment and sovereign spreads are from Neumeyer and Perri (2005), while all the other employment data in Table 2 come from Li (2011).…”

Fiscal Policy in an Emerging Market Business Cycle Model

“…To meet this working capital constraint, the …rm borrows from the government and from households by issuing debt. 17 The …rm issues corporate bonds to households to whom they promise a return of R P t 1 which is a mark-up over the existing international interest rate R t 1 : Firms can also borrow from the government at a subsidized interest rate R P t 1 (1 s) where 0 s < 1 is the subsidy. We assume however that only a …xed portion, G ; of the total …rm's working capital constraint, ; such that G can be borrowed from the government at the subsidized rate.…”

“…22 From the …rst order conditions for the representative agent with respect to bonds (17), at the steady state, we obtain…”

“…A crucial feature of this model is that households have GHH preferences (see Greenwood et al (1988)). GHH preferences shut o¤ the income e¤ect, making labor supply invariant to the income e¤ects associated with a positive interest rate shock (see Li (2011)). Consumption drops instantaneously and falls more than output due to the inter-temporal substitution e¤ect from a rise in real interest rates.…”