The Japan-U.S. Exchange Rate, Productivity, and the Competitiveness of Japanese Industries*

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2 1 The apan-u.s. Exchange Rae Producvy and he Compeveness of apanese Indusres* March 2009 Rober Dekle Deparmen of Economcs USC and Kyoj Fukao Insue of Economc Research Hosubash Unversy Wh he Asssance of Mura Ungor Deparmen of Economcs USC Absrac In hs paper we focus on he movemens of he yen on apanese ndusres and on he secoral reallocaon of apanese employmen. We show ha he apprecaon epsodes of 1985 and 1995 have sgnfcanly hur he ably of apanese ndusres o compee wh U.S. ndusres by rasng he relave producon coss of apanese ndusres. Ths relave cos gap wh U.S. ndusres narrowed from 1995 owng o faser wage growh n he U.S. and especally o hgher producvy growh n some apanese ndusres. In fac n hese hgh producvy apanese manufacurng ndusres such as chemcals and ranspor equpmen relave producon coss were essenally back o pre-1985 pre-plaza Accord levels by In conras he relave producon coss of apanese low producvy manufacurng ndusres such as exles and wood producs have remaned hgh. Clearly n he aggregae he apprecaon of he yen was no mached by an ncrease n apanese producvy. Wha hen s he apprecaon of he aggregae real exchange rae conssen wh hese apan-u.s. dfferences n ndusral producves? To answer hs queson we buld a hree-secor hgh producvy manufacurng low producvy manufacurng and servces equlbrum macroeconomc-rade model of apan and he U.S. We fnd ha whle he yen was undervalued before 1985 was sgnfcanly overvalued afer 1985 and especally snce In our model smulaons he Balassa-Samuelson effec s observed: he equlbrum real exchange rae s apprecang over me owng o srong relave growh n he apanese hgh producvy manufacurng secor bu very poor relave producvy growh n he apanese servces secor. Ineresngly he connued apprecaon of he equlbrum real exchange rae mean ha he acual real exchange rae was near s equlbrum value by when he nomnal yen dollar rae was abou 120 yen o he dollar. * We hank Ganluca Bengno ames Harrgan Ann Harrson Sam Korum and he Edors of he Economc and Socal Research Insue ESRI Projec especally Koch Hamada for very helpful commens on earler drafs. Rober Dekle hanks he Cener for Inernaonal Research on he apanese Economy a he Unversy of Tokyo for hosng hm durng he Summer of 2008 and o Yanyu Wu for helpful research asssance. A revsed verson of hs paper wll appear n an eded volume o be forhcomng a MIT Press.

3 2 I. Inroducon. In Sepember 1985 represenaves of he U.S. apan Germany he Uned Kngdom and France me a he Plaza Hoel n New York o engneer a deprecaon of he dollar o help elmnae he connung rade defcs of he U.S. As a consequence of hese polces by February 1986 he yen-dollar exchange rae approached 180 from abou 250 before he Plaza Accord Fgure 1. The yen connued o apprecae reachng 120 n early There was anoher spur of apprecaon n early 1995 wh he yen momenarly ouchng below 90. Subsequenly he yen weakened o as much as 130 alhough has mosly been n he range durng he las decade excep for he perod afer he fall of 2008 when he yen brefly ouched below 90 agan. 1 These rends n he apanese currency apply also n erms of he Nomnal Effecve Exchange Rae NEER alhough n erms of he Real Effecve Exchange Rae REER he yen apprecaon was more mued wh he REER back a pre-plaza levels by early In hs paper we focus on he movemens of he yen on apanese ndusres and on he secoral reallocaon of apanese employmen. We show ha he apprecaon epsodes of 1985 and 1995 have sgnfcanly hur he ably of apanese ndusres o compee wh U.S. ndusres by rasng he relave producon coss of apanese ndusres. Ths relave cos gap wh U.S. ndusres narrowed from 1995 owng o faser wage growh n he U.S. and especally o hgher producvy growh n some apanese ndusres. In fac n hese hgh producvy apanese manufacurng ndusres such as chemcals and ranspor equpmen relave producon coss were essenally back o pre-1985 pre-plaza Accord levels by In conras he relave producon 1 The effecs of he Global Fnancal Crss of 2008 on he yen-dollar exchange rae and on he compeveness of apanese ndusres are oo recen o be analyzed n hs paper.

4 3 coss of apanese low producvy manufacurng ndusres such as exles and wood producs have remaned hgh. Clearly n he aggregae he apprecaon of he yen was no mached by an ncrease n apanese producvy. Wha hen s he apprecaon of he aggregae real exchange rae conssen wh hese apan-u.s. dfferences n ndusral producves? To answer hs queson we buld a hree-secor hgh producvy manufacurng low producvy manufacurng and servces equlbrum macroeconomc-rade model of apan and he U.S. We fnd ha whle he yen was undervalued before 1985 was sgnfcanly overvalued afer 1985 and especally snce In our model smulaons he Balassa-Samuelson effec s observed: he equlbrum real exchange rae s apprecang over me owng o srong relave growh n he apanese hgh producvy manufacurng secor bu very poor relave producvy growh n he apanese servces secor. Ineresngly he connued apprecaon of he equlbrum real exchange rae mean ha he acual real exchange rae was near s equlbrum value by early 2003 when he nomnal yen dollar rae was abou 120 yen o he dollar. Fnally we use our model o examne he relaonshp beween hese apan-u.s. dfferences n average producon coss and he allocaon of employmen across he hree secors. In boh apan and n he U.S. de-ndusralzaon or he rse of he servce economy s of mporan polcy concern. Whle our model smulaons follow he declne n he employmen shares n hgh producvy manufacurng que well our model fals o capure he large flow of employmen from low producvy manufacurng o servces n boh counres. Ths falure s no smply because our long-run model canno capure he emporary employmen effecs of he overvaluaon of he yen. The dollar he

5 4 mrror mage of he yen was undervalued agans he yen bu he U.S. also experenced a declne n employmen n low producvy manufacurng. We sugges ha some hrd long-erm srucural facor such as he rse of Chna and Inda may be responsble for he surge n servce secor employmen n apan and n he U.S. As noed by Hamada and Okada 2007 and McKnnon and Ono 1997 he Plaza Accord shfed he exchange rae expecaons of marke parcpans upwards owards a sharp yen apprecaon. Afer he Accord marke parcpans became convnced ha he U.S. and apanese governmens would connue underake polces o apprecae he yen as long as apanese rade surpluses especally agans he U.S.-- remaned large. The yen connued o apprecae reachng a peak of slghly under 90 yen n Gven he sluggshness n he adjusmen of prces he real exchange rae apprecaed n andem. Ths apprecaon of he real exchange rae made apanese ndusres uncompeve agans comparable U.S. ndusres. The compeve dscrepancy was adjused over me hrough changes n relave apan-u.s. wages capal coss or dfferenal raes of echncal progress. In he long run hese adjusmens collecvely should resore he real exchange rae o s equlbrum value. However he resoraon of he real exchange rae o s equlbrum would ypcally ake a very long me. 2 As menoned n our model he long- or very long-run equlbrum real exchange rae s deermned largely by he Balassa-Samuelson effec ha s he producvy dfferenals beween apan and he U.S. apan s real exchange rae 2 Emprcally he speed a whch he real exchange rae reaches equlbrum pary s very slow. Accordng o Froo and Rogoff 1995 sandard esmaes of he real exchange half-lfe le n he range of hree o fve years. In our macroeconomc-rade model we show ha was only n 2003 when he real exchange rae was resored o s equlbrum value almos a full 20 years afer he Plaza Accord.

6 5 apprecaes over me because of he very rapd producvy growh n apan s hgh producvy manufacurng secor relave o he counry s unproducve servces secor. In conras n he U.S. he gap n producvy growh beween he hgh producvy manufacurng and he servces secors s no as large. Compared o our long- o very long-run analyss of apan-u.s. real exchange raes Lane 2008 hs volume s concerned wh more medum-run movemens n apan s real exchange rae. In he medum-run large credors such as apan wll experence an apprecaon of s real exchange rae as ne nvesmen nflows lead o an excess of domesc absorpon relave o domesc producon he ransfer effec. In our very long-run model rade s balanced and here s no ransfer effec. Obsfeld 2009 hs volume characerzes apanese real exchange raes from he shor- o he long-runs and depcs how busness cycles and moneary polces can change real neres raes and cause he shor-run real exchange rae o devae from s long-run value. Obsfeld shows ha he Balassa-Samuelson effec would appear o hold n he long- o he very long-runs alhough emprcally may ake more han 20 years whch s he lengh of me akes n our model for he real exchange rae o rever o s equlbrum value. Neher Lane nor Obsfeld examne he effecs of exchange raes on apanese ndusres or on apanese secoral employmen as we do n hs paper. In he nex Secon we frs analyze how he hgh yen rased he producon coss of apanese ndusres relave o hose n U.S. ndusres. 3 We wll compare n dollar erms--he average producon coss of 14 apanese and U.S. manufacurng ndusres. We show ha apanese average coss a he ndusry level have rsen subsanally 3 See also Dekle 2005 for an analyss usng frm level daa on how he hgh yen has hur he profably of apanese frms.

7 6 beween 1985 and Snce hen apan-u.s. gaps n average coss have narrowed somewha largely owng o more rapd wage ncreases n he U.S. In some key apanese ndusres producvy growh was rapd helpng close he average cos gaps wh U.S. ndusres. These apanese hgh producvy ndusres were n opcs ranspor equpmen and chemcal producs. In hese and n some oher ndusres apanese average coss n erms of dollars were almos he same as U.S. average coss by In ndusres n whch apanese producvy growh were relavely low such as rubber and plascs and exles and apparel he gaps n average coss beween apanese and U.S. ndusres remaned subsanal even n In Secon III we buld a smple long-run Rcardan apan-u.s. macroeconomcrade model ha endogenzes he real exchange rae and wage responses. 5 The model has hree secors: he low and hgh producvy manufacurng secors and he servces secor. We use he apan-u.s. producvy levels calculaed from he EU KLEMS daa and feed he producvy levels daa no our model. Usng our model and he producvy daa we smulae he apan-u.s. real exchange raes average coss and secoral employmen shares. Our smulaed apan-u.s. real exchange raes can be nerpreed as an equlbrum benchmark ha depends mosly on relave producvy dfferences beween apan and he U.S. and model parameers. Ths benchmark can be 4 In relaed work orgenson and Nomura 2005 calculae usng dealed commody level prces he purchasng-power pary PPP exchange raes beween apan and he U.S. and found ha for many of he 42 ndusres examned he acual yen-dollar exchange rae was much hgher han he PPP exchange raes. 5 The analyss a he ndusry level s of he shor o medum-runs a a horzon when real exchange raes can sll be devang from fundamenals say owng o a moneary or expecaons shock. In he long-run exchange raes and relave apan-u.s. wages are boh endogenous. For example a posve producvy shock o he apanese manufacurng secor wll apprecae he apanese real exchange rae and rase economy-wde apanese wages. The apprecaon of he yen and he ncrease n apanese wages wll rase average coss n apanese manufacurng. The ne effec of he posve producvy shock on apanese manufacurng average coss s hus ambguous n he long-run.

8 7 used o assess wheher acual apan-u.s. real exchange raes are msalgned. 6 We focus on undersandng he changng secoral employmen shares n apan and n he U.S. gven he wdespread polcy neres n he de-ndusralzaon of he manufacurng secor and he rse of servces secor n boh counres. We fnd ha our baselne model smulaons follow he apan-u.s. real exchange raes and he apan-u.s. gaps n average coss n boh he low and hgh producvy manufacurng secors que well over he long-run. As s expeced n our sac long-run framework whou money we mss mos of he shor-run flucuaons. Wh regards o he secoral employmen shares our baselne model smulaons follow he employmen shares n hgh producvy manufacurng que well and n he servces secors somewha well bu fal o follow he employmen shares n he low producvy manufacurng secor. II. The Changng Relave Average Producon Coss of apanese Indusres versus U.S. Indusres snce In hs Secon we wll analyze how he compeveness or U.S.-apan relave average coss have changed over me. We measure changes n he compeveness of apanese ndusres by esmang he changes n her average coss of producon n comparson wh he changes n he average cos of producon of U.S. ndusres. The change n average coss can be decomposed no he change n capal coss he change n wages he change n he cos of npu maerals and fnally he change n oal facor producvy. 6 In Obsfeld and Rogoff 2005 and Dekle Eaon and Korum 2008 he equlbrum real exchange rae s defned as he rae a whch he curren accouns n all counres would be equal o zero.

9 8 II.1: Mehodology and he Daa. We begn by explanng our mehodology and basc assumpons. Suppose ha here exss a well behaved consan reurns o scale producon funcon for a represenave frm n ndusry of counry of he followng form: T X K L F Y 1 where Y denoes he real gross oupu of hs frm a me L s he labor npu K he capal servce npu X he npu of nermedae goods and T he echnology level. The average cos of producon of hs frm C z s expressed by Y X q K r L w C 2 where w denoes he nomnal wage rae measured n counry s currency for workers n ndusry of counry a me r represens he capal servce prce and q he nermedae npu prce. We assume ha each frm s a prce aker n all facor markes. We also assume ha facor prces and he echnology level T are connuous funcons of me. By dfferenang equaon 2 over me and usng cos mnmzaon condons we oban ˆ ˆ ˆ ˆ ˆ A q s r s w s C X K L 3 where he crcumflex accens denoe he growh rae of varables. s L s K and s X denoe he cos share of each producon facor:

10 9 X q K r L w X q s X q K r L w K r s X q K r L w L w s L L L A denoes he oal facor producvy TFP level of ndusry n counry a me. The TFP growh rae can be defned by ˆ Y d dt T F A Usng growh accounng we can esmae he TFP growh rae. Equaon 2 shows ha we can explan he relave compeveness whch we measure by he gap n he average coss of producon of he wo counres n each ndusry by he gap n facor prces beween he wo counres and he gap beween her TFP levels. In order o apply equaon 2 o dscree me-seres daa we use a Tornqvs-ype approxmaon of hs equaon: 1 ln ln 1 ln ln ln ln ln ln ln ln A A q q s s r r s s w w s s C C X X K K L L 4 We use year 1980 as he benchmark year and se C 1980=100.

11 10 We can measure he ner-emporal changes n he compeveness of ndusry n counry n comparson wh ha of ndusry n counry U by he changes n he rao of he average cos of producon n he wo counres measured n he same currency: ec / C U* where e denoes he nomnal exchange rae ndex beween he currences of he wo counres he value of counry s currency n erms of counry U s currency. We use year 1980 as he benchmark year and se e1980=100. Here we brefly explan our daa. Deals on daa consrucon are gven n Appendx 1. We have daa on 19 ndusres n boh counres 13 n manufacurng 6 n servces. Daa on he followng facor npus and on he TFP growh rae were obaned from he EU KLEMS Daabase March 2008 verson. w L : nomnal labor compensaon n ndusry n counry ; w : labor compensaon dvded by he qualy adjused labor npu ndex 1995=100 of ndusry n counry ; q X : nomnal nermedae npu cos of ndusry n counry ; q : nermedae npu cos dvded by he real nermedae npu ndex 1995=100 of ndusry n counry ; and lna lna 1: TFP growh rae of ndusry n counry. We esmaed he servce prce of capal as follows: r =gross fxed capal formaon prce ndex all asses 1995=100 neres rae + deprecaon rae capal gans We obaned he gross fxed capal formaon prce ndces from he EU KLEMS Daabase. We calculaed he capal gan erms from hese ndces. For neres raes we use he yeld of newly-ssued 10-year governmen bonds for apan and he marke yeld

12 11 on 10-year US Treasury secures for he US. Deprecaon raes were obaned from he apan Indusral Producvy IP Daabase for apan and from he BEA webse for he U.S. To measure capal servce npus we used he real capal sock n 1995 prces from he EU KLEMS Daabase. For he yen-dollar exchange raes we used he annual average nerbank marke exchange rae from Nkke NEEDS. II.2: apan-u.s. Producvy and Average Cos Comparsons. If he apprecaon of apan s real exchange rae Fgure 1 had been accompaned by superor producvy growh n comparson wh oher counres hen he apprecaon of he Yen unl he md-1990s would no have reduced he nernaonal compeveness of apan s manufacurng secor. However n many manufacurng ndusres he TFP growh acheved was no suffcen o cancel ou he effecs of he Yen apprecaon. In parcular from he 1990s apan s TFP sagnaed and apan s manufacurng ndusres los n compeveness. Fgure 2 compares he TFP growh of manufacurng ndusres n apan and n he U.S. In he perod TFP growh raes n mos manufacurng ndusres n apan were hgher han hose n he U.S. However durng TFP growh n almos all manufacurng ndusres became very low n apan wh he excepon of he elecrcal and opcal equpmen ndusres and U.S. TFP growh n mos manufacurng ndusres exceeded apan s. Fgure 3 Panel A shows how average producon coss have changed over me n apan and n he U.S. n he elecrcal and opcal equpmen ndusry. Producon coss wll fall when here s a declne n wages capal coss maerals coss or a rse n TFP. In dollar erms apanese producon coss wll rse when he yen apprecaes. Fgure 3

13 12 shows ha holdng he yen consan apanese producon coss n he elecrcal and opcal equpmen ndusry have rended along wh U.S. producon coss. However n erms of dollars apanese producon coss n hs ndusry surged afer he yen apprecaon n 1985 reachng a peak a abou Thereafer apanese producon coss n erms of dollars sared o declne gradually approachng U.S. levels by To see he role of wage rae and producvy changes on apan-u.s. relave average producon coss Fgure 3 Panel B shows ha relave o apanese wages U.S. wages have surged especally snce 1995 conrbung o he convergence of apan-u.s. average coss. apanese TFP growh raes have generally been lower han U.S. TFP growh raes excep for he perod afer 2002 n he elecrcal and opcal equpmen ndusry. Fgures and 7 depc smlar daa for he rubber and plascs he exles apparel leaher and foowear he ranspor equpmen and chemcals and chemcal producs ndusres respecvely. 7 Generally he paerns observed n hese ndusres are smlar o he paern observed n he elecrcal and opcal equpmen ndusry. Frs he yen apprecaon sharply deeroraed he compeveness of apanese ndusres sarng n However he rapd ncrease n U.S. wage raes has parally offse he drop n apanese compeveness. The declne n capal cos and nermedae npu prces n apan unrepored o conserve space also conrbued o offseng he effec of he yen apprecaon. 7 We creaed smlar fgures for oher manufacurng ndusres general machnery; basc and fabrcaed meals; oher non-meallc mnerals; coke refned peroleum and nuclear fuel; food beverages and obacco; wood and of wood producs; pulp paper prnng and publshng; and manufacurng no elsewhere classfed and recyclng. However o conserve space we om hese fgures.

14 13 Second apan s compeveness relave o he U.S. reached boom n Ths resul s conssen wh he fac ha apan s real effecve exchange rae REER was mos apprecaed n 1995 along wh he yen-dollar rae and he nomnal effecve exchange rae Fgure 1. Afer ha he yen gradually deprecaed n REER erms and by 2006 he real effecve exchange rae approached he level of he level of Thrd n ndusres where apan s TFP growh were on par wh or hgher han ha of he U.S. before 1990 such as elecrcal and opcal equpmen ranspor equpmen chemcals and chemcal producs general machnery and pulp paper prnng and publshng he apan-u.s. average cos gap n dollars dd no become very large even n 1995 and becomes neglgble by On he oher hand n ndusres where apan s TFP growh was much smaller han ha of he U.S. before 1990 such as rubber and plascs exles apparel leaher and foowear basc meals and fabrcaed meal and food beverages and obacco he apan-us gap n he average cos of producon measured n dollars became very large n 1995 and even now remans szable. III. apan-u.s. Producvy Dfferences Real Exchange Raes and Secoral Employmen Shares n he Long-run: A Three-Secor Two-Counry Model. The prevous Secon showed ha as he yen apprecaed apanese average producon coss rose relave o U.S. average producon coss on an ndusry-byndusry bass. The relave rse n apanese average coss was larger n ndusres where he ncreases n TFP growh were lower. For example afer he yen apprecaon apanese average coss rose subsanally relave o U.S. average coss n exles--a low producvy ndusry--whle n ranspor equpmen a hgh producvy ndusry

15 14 apanese average coss relave o U.S. average coss were relavely consan over me. The analyss n he prevous Secon s of he shor- o medum-runs when nomnal exchange raes can devae from her Purchasng Power PPP values. In he shor- o medum-runs gh moneary polces n apan can apprecae he yen and rase apan s relave average coss as happened n apan beween 1990 and 1995 Hamada and Okada However n he long-run here s a endency for Purchasng Power Pary o hold n he sense ha nomnal exchange rae changes approach he changes n relave prces Taylor and Taylor Thus here s lkely o be movemen of nomnal exchange raes owards purchasng power pary whn our sample perod of 20 years or more. The real exchange rae smulaed by our long- o very long-run model below should be vewed as an equlbrum benchmark by whch he overvaluaon or he undervaluaon of he acual real yen-dollar exchange rae can be evaluaed. We wll focus on he mpac of producvy dfferences beween apan and he U.S. on apan-u.s. real exchange raes and apanese secoral employmen paerns. To adequaely analyze he mpac of producvy dfferences on real exchange raes and he allocaon of employmen across secors we need a general equlbrum model. A negave shock o apanese producvy wll on he one hand drecly rase average coss by lowerng effcency whle on he oher hand lower average coss by lowerng wages and deprecang he apanese yen. Thus a producvy shock has offseng effecs on average coss and s unclear whch effec wll domnae n a paral equlbrum seup. Moreover ndusry-by-ndusry average cos comparsons canno gve a complee pcure of a counry s nernaonal compeveness. Dfferences n apan-u.s. average coss n

16 15 a hrd secor--such as he servces secor can aler he apanese manufacurng secor s compeveness hrough he Balassa-Samuelson effec. We aggregae our 19 ndusres from he EU-KLEMS daa descrbed n Secon II and n Appendx 1 no 3 secors he 1 low labor producvy manufacurng secor he 2 hgh labor producvy manufacurng secor and he 3 servces secor. In our model here are wo counres apan and he U.S. and hey each produce and consume he goods n he 3 secors. The manufacurng secors n he wo counres are dfferenaed. In fac we fnd afer calbrang from he daa ha apanese low and hgh producvy manufacurng and U.S. low or hgh producvy manufacurng goods have very low subsuably n he consumpon decsons of apanese and U.S. households. 8 III.1: Aggregang he 19 Indusres no 3 Secors and he Daa on Secoral Labor Producves. The model s a smple Rcardan ype wh no capal and labor as he only facor of producon Y j =Ɵ j L j where Ɵ s labor producvy n ndusry and counry j. 9 We can relae Ɵ o TFP j n he prevous Secon f he producon funcon s Cobb- Douglas snce hen Ɵ n each ndusry omng he subscrps s equal o where 1-α s he labor share of ncome r s he real rae of neres assumed consan and A s he level of TFP. The growh n labor producvy s hen smply equal o: 8 The calbraed Armngon elasces beween apanese and U.S. low producvy goods and hgh producvy goods are and respecvely Table A1 n Appendx 2. These calbraed elasces are lower han he values of 3 o 6 used n Obsfeld and Rogoff s 2007 smulaons. Our model also allows for home producon whch capures soco-economc phenomena such as he declne n housework and chld- and elder-care by apanese households. These phenomena wll ncrease he demand for non-radeable servces and rase he relave prce of servces n apan hereby helpng apprecae he equlbrum real exchange rae Messna For more deals on he model see Appendx 2.

17 16 grɵ= Usng he growh n TFP by ndusry and he labor shares by ndusry calculaed n he prevous Secon from EU-KLEMS and descrbed n Appendx 1 we can hen calculae he growh n labor producvy for each of our 19 secors 13 n radeables manufacurng 6 n nonradeable servces. We rank each of our 13 ndusres n manufacurng accordng o he average growh of apanese labor producves n hese ndusres beween 1978 and As a resul of hs rankng procedure we classfy he followng sx manufacurng ndusres as Low Producvy Indusres hese ndusres had he sx lowes average labor producvy growh raes: 1 food 2 exles 3 wood 4 pulp and paper 5 refned peroleum and 6 basc and fabrcaed meals. We classfy he followng seven manufacurng ndusres as Hgh Producvy Indusres : 1 chemcals 2 rubber 3 non-meallc meals 4 basc machnery 5 elecroncs and opcal machnery 6 ranspor equpmen and 7 manufacurng no elsewhere classfed. The Servces Indusres nclude 1 hoels 2 ranspor and sorage 3 poss and elecommuncaons 4 fnancal nermedaon 5 real esae and 6 oher busness servces. To smulae our model we need daa on labor producvy labor supply oupu n dollars and prces n dollars for each of our hree secors for boh apan and he U.S. Labor supply s defned as he oal number of hours worked n ha parcular secor. Labor producvy s hus n erms of oupu per hour. For each of he hree secors we form weghed averages of he daa for he ndusres ha comprse ha parcular secor where he ndusry s oupu share n ha secor s used as he wegh for ha ndusry.

18 17 Fgure 8 depcs he daa for labor producves so consruced from 1980 o Ths s he daa ha we feed no he model o smulae our seres for he apan- U.S. relave average coss he apan-u.s. real exchange rae and he secoral labor shares. The uns are n erms of he numerare secor apanese Low Producvy manufacurng. Labor producvy n 1980 n he apanese Low Producvy secor s se o uny. Thus we can compare labor producvy levels no only beween apan and he U.S. bu also across he hree secors. We can see from he Fgure ha n he Low Producvy Indusres labor producvy n apan was declnng slghly durng hs perod whle n he U.S. labor producvy was rsng. In he Hgh Producvy Indusres labor producvy growh was hgh n boh counres especally n he U.S. unl abou Snce hen apanese labor producvy growh has ousrpped U.S. labor producvy growh n hs secor especally snce In Servces labor producvy growh n boh counres was fla. The level of labor producvy n Servces n apan compared o ha n he U.S. s especally low. III.2: The Balassa-Samuelson Effec and Real Exchange Raes. In Fgure 9 we compare he real exchange rae n he daa wh he real exchange rae smulaed from he model. For he daa he real exchange rae s defned as he rao of he weghed GDP deflaors n he wo counres n erms of dollars. To conver he apanese GDP deflaor no dollars we use 1 he nomnal yen-dollar exchange rae and 2 he yen-dollar exchange rae adjused for Purchasng Power Pary from Heson Summers and Bena The model smulaed real exchange rae he marke real exchange rae and he Purchasng Power Pary real exchange rae are all assumed o be

19 18 equal around Tha s all hree exchange raes are assumed o be n equlbrum n In he model he real exchange rae s defned as he rao of he weghed averages of he hree secors n apan and n he U.S. n erms of a common numerare n our case he Low Producvy manufacurng secor n apan. Snce n he daa he gap n producvy growh beween servces and n manufacurng s wder n apan han n he U.S. from Fgure 8 we should fnd aggregae prces n apan rsng faser han aggregae prces n he U.S. he Balassa-Samuelson effec. Fgure 9 shows ha n he long- o very long runs he real exchange rae as smulaed from our model maches he daa well especally when he nomnal yen-dollar exchange rae s used o conver he apanese GDP deflaor o U.S. dollars. Specfcally we observe he Balassa-Samuleson effec-- an apprecaon of he apanese real exchange rae over he long-run. Unsurprsngly n our model wh no money and no prce rgdes we mss mos of he shor- and medum-run flucuaons n he real exchange rae. If we ake our smulaed real exchange rae seres as a long-run benchmark we fnd ha he acual real exchange rae was undervalued unl 1985 bu was overvalued beween 1986 and Noe ha by 2003 whle he yen s overvalued n comparson o he Heson Summers and Bena PPP real exchange raes s slghly undervalued n comparson o our model smulaed real exchange raes. Obsfeld 2009 hs volume shows ha over he shor- o medum-runs devaons from he Balassa-Samuelson benchmark are subsanal. Lane 2008 hs volume fnds ha he yen-dollar exchange rae s conegraed wh apan-u.s. producvy dfferenals suggesng ha Balassa-Samuelson holds n he long- o very

20 19 long-runs. We fnd more evdence han does Obsfeld ha he yen-dollar real exchange rae revers o s benchmark equlbrum over he long-run. Ths s probably because our model used o smulae he equlbrum benchmark s somewha more general han he usual Balassa-Samuelson model where he real exchange rae depends only on he wo counres dfference n dfferences beween her radeable-secor and nonradeablesecor producvy growh raes. In our model n addon o he usual Balassa- Samuelson producvy dfferenals we have hree raher han wo secors wh each secor for example he Low Producvy manufacurng secor producng hghly dfferenaed goods n apan and n he U.S. We also have home producon n each counry whch gven our parameer values n Table A1 wll end o rase he relave prce of Servces n apan resulng n an apprecaon of he model smulaed real exchange rae ha beer maches he long-run apprecaon of he acual yen-dollar real exchange rae. III.3: Secoral Average Coss and Secoral Employmen Shares. Average cos n our framework s equal o: κ where n boh counres κ s a consan and w are wages n dollars. As n he prevous Secon average coss n apan wll rse relave o average coss n he U.S. when 1 apanese producvy growh s lower han U.S. producvy growh; or 2 when apanese wages grow faser han U.S. wages eher because of faser wage growh or because of an apprecaon of he yen whch rases apanese wages n dollar erms. Noe however ha boh w and he real dollar-yen exchange raes depend on economy-wde labor producves ncludng producvy n he Servces secor wh lower apanese relave producvy n he

21 20 Servces secor lowerng apanese relave wages bu apprecang he yen. Thus he ne effec of producvy growh on apan-u.s. average coss s ambguous. In Fgure 10 we depc he raos of apanese average coss o U.S. average coss boh n he daa and n he model. As n he prevous Secon n he daa apanese average coss rse sharply relave o U.S. average coss sarng from abou 1985 and peakng around From 1995 he closng of apan s average cos gap wh he U.S. s much slower n he Low Producvy secor because apan s producvy growh s lower han n he U.S. n hs secor. Thus he closng of he average cos gap occurs enrely due o he rse n relave U.S. wages. By 2003 n he Hgh Producvy Indusres average coss n apan relave o hose n he U.S. are lower han even n 1980 sgnfyng he sharply mproved compeveness of apanese Hgh Producvy Indusres snce Ths s no only because of hgher apanese producvy n hs secor bu also because of he rse n relave U.S. wages. Recall ha snce here s full ner-secoral mobly of labor wages n all hree secors are equalzed. Economy-wde wages are deermned by rade paerns and whn counry aggregae producvy ncludng producvy n Servces whch s hgher n he U.S. The model racks he long-run rends n he relave coss que well alhough we mss he yen apprecaon epsodes beween 1985 and As menoned hese are clearly epsodes when he nomnal yen apprecaon depared from he economc fundamenals of apan and our model drven enrely by producvy growh and oher fundamenals canno capure hese epsodes. We have shown ha slower relave producvy growh n he Servces Indusres wll end o apprecae he real exchange rae n he long run. Many observers also e o

22 21 he faser growh of producvy n radable goods he declne n employmen n he manufacurng secors of ndusralzed counres he so-called de-ndusralzaon hypohess. The economc reasonng s smple: wh fewer workers able o produce a hgher volume of manufacurers some workers wll have o swch jobs o Servces. As Obsfeld and Rogoff 1996 Ch. 4 and Masuyama 2008 pon ou however hs smple reasonng does no accoun for he fac ha demand for and hereby employmen n manufacurers n a parcular counry may fall off owng o he declne n her prce n he global marke because of oversupply or ncreased global compeon. The change n manufacurng employmen generally depends n a complcaed way on secoral demand elasces boh domesc and abroad. Tha s he de-ndusralzaon hypohess focuses on echnologcal change and whn counry producvy growh bu generally gnores he mpac of nernaonal rade. The de-ndusralzaon hypohess should be examned n a leas a wocounry general equlbrum framework wh endogenously evolvng relave prces. Below we depc smulaons of he changes n he labor shares n boh apan and n he U.S. usng our model s calbraed elasces. We also compare our model smulaons wh wha acually happened o he labor shares n he hree secors n apan and n he U.S. beween 1978 and For our parameer values n Table A1 he model predcs ha employmen shares of he Hgh Producvy Indusres n boh counres should be decreasng. The employmen shares n he Low Producvy Indusres and n he Servces Indusres should be ncreasng Fgure 11. Our model racks he acual employmen shares n Hgh Producvy manufacurng exremely well for n boh counres. However he

23 22 employmen shares n he Servces Indusres are ncreasng more sharply n he daa han n he model. Also n he daa he employmen shares n Low Producvy manufacurng are declnng dramacally whle n he model hese shares are ncreasng. Thus whle our model capures he rends n he Hgh Producvy Indusres reasonably well our model fals o capure he downward rend n employmen n he Low Producvy Indusres and upward rend n employmen n he Servces Indusres. In parcular our model fals o capure n boh counres he dramac acual movemens of labor from Low Producvy manufacurng o he Servces secor. Our model s smulaon resuls are robus o rasng he Armngon elasces n he Low Producvy Indusry o 1.5; and o rasng he consumpon uly weghs 1 of Low Producvy goods from 0.1 o 0.2 or 0.3 n boh counres. Why does our model fal n hs mporan dmenson? In boh he U.S. and n apan acual producvy growh n Low Producvy manufacurng s jus oo low o drve ou labor o he Servces secor. In our model we would need labor producvy growh n Low Producvy manufacurng of over 4 percen per year o have suffcen labor mgraon from he Low Producvy secor o he Servces secor a rae of labor producvy growh much hgher han wha s observed n he daa of boh counres. The falure of our model s no smply because our long-run model canno capure he emporary employmen effecs of he overvaluaon or msalgnmen of he yen. The dollar he mrror mage of he yen was undervalued agans he yen bu he U.S. also experenced a declne n employmen n Low Producvy manufacurng. The devaon of he yen-dollar exchange raes from economc fundamenals canno explan

24 23 he declne n low producvy manufacurng employmen n boh counres. There mus be some oher facor. The oher facor may be he rse of Inda and Chna counres ha are specalzed n ndusres such as exles and apparel ndusres whch are classfed as Low Producvy manufacurng n apan and n he U.S. As Broda and Wensen 2008 noe n 1992 he U.S. expored hree mes as much o apan as Chna; by 2005 Chna was exporng wce as much o apan as he U.S. Thus Chna oday may be a more mporan radng parner o apan han s he U.S. As Coleman 2007 pons ou he rse of hese Gans can heorecally lead o de-ndusralzaon n ndusral counres such as apan and he U.S. An neresng emprcal exercse usng our basc framework would be o combne Chna Inda and he U.S. no he res-of-he-world and examne how he changng secoral labor producves n he res-of-he-word would mpac he evoluon of Low Producvy manufacurng n apan. IV. Concluson. The man objecve of hs paper s o ry o beer undersand he relaonshps among apanese producvy growh he apan-u.s. real exchange rae and long-run economc oucomes such as apanese employmen. As he yen apprecaed sarng n 1985 apanese compeveness --defned as he rao of U.S. average coss o apanese average coss sharply declned. However he declne n apanese compeveness dffered among ndusres. In ndusres where apanese producvy growh was relavely hgh he declne n apanese compeveness was much smaller.

25 24 A comparson of he acual real exchange rae wh hs paper s long-run equlbrum benchmark shows ha he apanese real exchange rae was near equlbrum n 2003 when he nomnal yen-dollar exchange rae was around 120 yen o he dollar. The recen rapd apprecaon of he yen o below 90 yen o he dollar owng o he Global Fnancal Crss s hus clearly excessve and has resuled n large prof and employmen losses for apanese manufacurers. Our analyss suggess ha a reurn of he yen-dollar rae o above 120 should help resore profably o apanese manufacurers.

26 25 Appendx 1: Defnon of Varables Used n he Emprcal Analyss and Daa Sources The purpose of hs Appendx s o provde an explanaon of he daa whch we used for our emprcal analyss. Quanes and Prces of Oupu and Facor Inpu by Secor In he case of oupu and nermedae npu prces and quanes by secor we used he EU KLEMS Growh and Producvy Accouns March 2008 Release downloadable a hp:// A dealed explanaon of he mehodology and daa sources of he EU KLEMS can be founded n Tmmer e al. 2007a and 2007b. The major daa source for he EU KLEMS Accouns on apan s he apan Indusral Producvy IP Daabase downloadable a hp:// IP2008/ndex.hml. A dealed explanaon of he mehodology and daa sources of he IP Daabase can be founded n Fukao e al The mos recen verson of he IP Daabase IP 2008 was jonly compled by he Research Insue of Economy Trade and Indusres RIETI and Hosubash Unversy. Orgnal daa for he EU KLEMS Accouns on he Uned Saes are provded by he Bureau of Economc Analyss and Dale orgenson of Harvard Unversy and scholars who joned hs projec. The EU KLEMS Accouns provde nomnal and real values and mplc prce ndces of gross oupu value added and nermedae npus for abou seveny secors whch cover he whole economy of apan and he Uned Saes. For he aggregaon of hese ndces he Tornqvs mehod was used. The orgnal sources for hese daa are he SNA sascs for apan and he Uned Saes as well as background daa such as npu-oupu ables. Assumng consan reurns o scale fully compeve facor and oupu markes and full ulzaon of facor npus he TFP growh rae n secor of counry s derved usng sandard growh accounng: Qˆ Lˆ Kˆ Xˆ Aˆ A1 L K X where he crcumflex accens denoe he growh rae of varables he ner-emporal change of each log value from o +1. Q L K X and A denoe gross oupu labor servce npu capal servce npu nermedae npu and he TFP level respecvely. ν L ν K and ν X denoe he compensaon share of each producon facor. The growh rae of capal servce npu s derved by weghng he growh of each ype of fxed asse by he share of each asse s capal cos n oal capal cos as follows: K ˆ Sˆ k k k A2 where ν k denoes he share of capal cos of asse k n oal capal cos and S k denoes he sock of asse k whch s esmaed by applyng he perpeual nvenory mehod and geomerc deprecaon raes on nvesmen flow daa by ndusry and by asse. Three ypes of ICT asses offce and compung equpmen communcaon equpmen and sofware and four ypes of non-ict asses ranspor equpmen oher machnery and equpmen resdenal buldngs and nonresdenal srucures are reaed as dfferen ypes of asses. The growh rae of labor servce npu s derved by weghng he growh of man-hour npu of each ype of labor by he share of compensaon for each ype of labor n oal labor compensaon as follows:

27 26 L ˆ Hˆ l l l A3 where ν l denoes he share of compensaon for ype l labor n oal labor compensaon and H l denoes he oal hours worked by ype l labor. For hs calculaon daa on hours worked and labor compensaon are cross-classfed by he sex educaon an employmen saus of workers. In our calculaon of he cos share of each producon facor for equaon 3 we used he oal labor compensaon and oal nermedae npu cos n each ndusry whch are ncluded n he EU KLEMS Accouns. In he case of capal cos we dd no use he capal compensaon from he EU KLEMS Accouns. The reason s ha capal compensaon n he EU KLEMS accouns ncludes wndfall profs and mark-ups. Insead we esmaed capal coss ourselves. Our mehod s explaned below. Capal Cos and Exchange Raes The cos of capal by secor for he Uned Saes and apan are calculaed as follows: Capal cos user cos real fxed capal sock all asses 1995 prces where he real fxed capal sock s aken from he EU KLEMS Accouns. The user cos of capal for each secor s derved by User cos =gross fxed capal formaon prce ndex all asses 1995=100 neres rae + deprecaon rae capal gan from fxed capal sock We obaned gross fxed capal formaon prce ndces from he EU KLEMS Accouns. As neres raes for apan we used daa on yelds on newly-ssued governmen bonds 10 years downloaded from he Bank of apan webse hp:// research/sa/marke/bondmk/bondyeld/ndex.hm. For he Uned Saes we used he marke yeld on U.S. Treasury secures 10-year consan maury quoed on an nvesmen bass downloaded from he Federal Reserve Board webse hp:// We obaned he average deprecaon raes of all asses for each ndusry from he IP 2008 and BEA Daa. As yen-dollar exchange raes we used he annual average value of he yen-dollar exchange rae daa of Nkke Economc Elecronc Daabase Sysems NEEDS.

28 27 Appendx 2: The Two-Couny Three-Secor Rcardan Model 10 We develop a hree-secor wo-counry general equlbrum Rcardan model wo secors produce raded goods and one secor produce non-raded good n whch goods are dfferenaed by he producvy wh whch hey are domescally produced. Ths feaure of he model and he degree of subsuably n preferences beween home and foregn produced uns of each good endogenously deermne a counry s equlbrum paern of producon and rade. We denoe wo counres by P and US. There s no nernaonal labor mobly bu perfec labor mobly across secors. Frms There s connuum of frms producng each good. Frms behave compevely akng he prces of he producon goods and of he facor of producon as gven. Each good s produced usng one facor of producon labor n lnear echnology whch s gven by Y j j N j for ndusry j n counry. Here j denoes he secor specfc producvy ha changes over me and N j s he secoral employmen. Producves n he model are exogenous and are aken from he daa. The problem confroned by secor j n counry s he problem of maxmzng profs subjec o he producon echnology. The frs order condons for he producers problem mply ha he quany of each good j produced and he quany of facors hred n he ndusry sasfy ha w p j j where p j s he producer prce of he good j n counry and Agens and Preferences w s he wage rae n counry. There s a represenave agen n each counry who consumes all hree ypes of goods and works. Consumpon s he only deermnan of he uly funcon whch s gven by C C C s U log Here C 1 and Specfcally C j C 2 are deermned by he Armngon Aggregaors and C 1 and C 2 are gven by 1 1 j j1 j j j j C C j j P 1 j j US. C 3 s he non-raded good. Parameer s he elascy of subsuon beween he dfferen goods. Parameer s s he home consumpon of servce acves Messna The weghs j nfluence how consumpon expendure s allocaed across goods n each counry. We use he Armngon assumpon: producs from dfferen counres are mperfec subsues. Parameer s he elascy of subsuon Armngon elascy j beween domescally produced and mpored goods for secor j. Parameer of bas n preferences owards he goods produced n apan s whereas 1 represens he parameer of bas n preferences owards j j he Amercan goods. The represenave consumer n apan solves he problem of maxmzng he uly subjec o he followng budge consran 10 Wren by Mura Ungor. The complee verson of he appendx wll be avalable a: hp://www-scf.usc.edu/~ungor/

29 28 p AP AP AP AP US AP US AP AP AP AP 1 C1 AP p2 C2 AP p1 C1 US p2 C2 US p3 C3 w. The represenave consumer n he U.S. solves a symmerc problem. Trade s balanced snce here s no neremporal lendng/borrowng AP US AP US US AP US AP p 1 C1 AP p2 C2 AP p1 C1 US p2 C2 US. Resource consrans for labor n each counry are gven by N 1 N2 N3 1. Resource consrans for P P US US US P raded secors are gven by Y j C j P C j P and Y j C j US C j US. Resource consran for P P US US non-raded secors are gven by Y3 C3 and Y3 C3. The Real Exchange Rae The blaeral real exchange rae a any dae beween apan and he Uned Saes s gven by RER P.The aggregae prce ndex for counry s smply gven by YN YN YN YR YR YR P where YN j s he nomnal value added for secor j n counry whle YR j s he correspondng real value added n ha secor. US P AP Table A1: Model Parameer Values Secoral Armngon Elasces 1 Low Producvy; 2 Hgh Producvy = Preference Bas Toward apanese Goods 1 n Low Producvy; 2 n Hgh Producvy Oher Parameers U U U

30 29 References Broda C. and D. Wensen 2008 Exporng Deflaon? Chnese Expors and apanese Prces NBER Workng Paper Coleman Accommodang Emergng Gans mmeographed Duke Unversy. Dekle R Exchange Rae Exposure and Foregn Marke Compeon: Evdence from apanese Frms ournal of Busness 78 1 pp Dekle R. Eaon. and S. Korum 2008 Global Rebalancng wh Gravy: Measurng he Burden of Adjusmen IMF Saff Papers 553. Froo K. and K. Rogoff 1995 Perspecves on PPP and Long-Run Real Exchange Raes n G. Grossman and K. Rogoff eded Handbook of Inernaonal Economcs Vol. III. Amserdam: Norh-Holland. Fukao K. Inu T. Kubo S. and D. Lu An Inernaonal Comparson of TFP Levels of apanese Korean and Chnese Lsed Frms manuscrp Hosubash Unversy. Fukao Kyoj Sumo Hamagaa Tomohko Inu Keko Io Hyeog Ug Kwon Tasuj Makno Tsuomu Myagawa Yasuo Nakansh and oj Toku 2007 "Esmaon Procedures and TFP Analyss of he IP Daabase 2006" RIETI Dscusson Paper 07-E- 003 downloadable a hp:// Hamada K. and Y. Okada 2007 Moneary and Inernaonal Facors Behnd apan s Los Decade: From he Plaza Accord o he Grea Inervenon mmeographed Yale Unversy; Heson A. R. Summers and A. Bena Penn World Table Verson 6.2 Cener for Inernaonal Comparsons of Producon Income and Prces a he Unversy of Pennsylvana Sepember orgenson D. and K. Nomura 2005 The Indusry Orgns of apanese Economc Growh ournal of he apanese and Inernaonal Economes Lane P Inernaonal Fnancal Inegraon and apanese Economc Performance hs Volume. Masuyama K Srucural Change n an Inerdependen World: A Global Vew of Manufacurng Declne ournal of he European Economc Assocaon forhcomng. Messna The Role of Produc Marke Regulaons n he Process of Srucural Change European Economc Revew

31 30 McKnnon R. and K. Ohno 1997 Dollar and he Yen Cambrdge: MIT Press. Obsfeld M. and K. Rogoff 1996 Foundaons of Inernaonal Macroeconomcs MIT Press. Obsfeld M. and K. Rogoff 2005 Global Curren Accoun Imbalances and Exchange Rae Adjusmens Brookngs Papers on Economc Acvy Obsfeld M Tme of Troubles: The Yen and apan s Economy hs Volume. Taylor A. and M.P. Taylor 2004 The Purchasng Power Pary Debae ournal of Economc Perspecves Tmmer Marcel Mary O'Mahony and Bar van Ark 2007a The EU KLEMS Growh and Producvy Accouns: An Overvew Unversy of Gronngen & Unversy of Brmngham downloadable a hp:// Tmmer Marcel Ton van Moergasel Edwn Suvenwold Gerard Ypma Mary O Mahony and Mar Kangasnem 2007b EU KLEMS Growh and Producvy Accouns Verson 1.0 Par I Mehodology Unversy of Gronngen & Unversy of Brmngham downloadable a hp:// Producvy_Accouns_Par_I_Mehodology.pdf. Ungor M De-ndusralzaon of he Rches and he Rse of Chna mmeographed USC.

32 Fgure 1: Exchange Raes Nomnal Effecve Real Effecve Nomnal Dollar-Yen :100

33 Panel A Panel B

34 Panel A. Average Coss Panel B. Wage Raes and TFP 33

35 34

36 35

37 36

38 37

39 38 Fgure 8: Labor Producvy Oupu per Hour n Low Producvy Manufacurng Hgh Producvy Manufacurng and n Servces n apan and n he U.S. Doed: U.S. Labor Producvy; Dashed: apanese Labor Producvy.

40 Fgure 9: The Rao of he Prce Index of apanese Goods o he Prce Index of U.S. Goods Marke Dollar-Yen Exchange Rae Purchasng Power Pary PPP Exchange Rae and Model Smulaed Equlbrum Real Exchange Rae. Sold: Evaluaed a Marke Exchange Rae; Doed: A PPP Exchange Rae; Dashed: Model Smulaed Exchange Rae. 39

41 Fgure 10: The Rao of apanese Average Un Coss o U.S. Un Coss Daa and Model Smulaed Resuls. Sold: Daa; Dashed: Model. 40

42 Fgure 11: Share of Secoral Employmen n Toal Employmen. Sold: Daa; Dashed: Model. 41