Labor Mobility and Exchange Rate Regime in Open Economies

Transcription

1 Labor Mobiliy and Exchange Rae Regime in Open Economies David Cook Hong Kong Universiy of Science and Technology Haichao Fan Hong Kong Universiy of Science and Technology Juanyi Xu Hong Kong Universiy of Science and Technology February 213 Absrac In his model, we sudy he impac of labor mobiliy on he choice of exchange rae regime in an open economy New Keynesian model wih compeiive labor markes. When we focus on demand shocks, we find resuls which are very similar o he sandard Mundell opimal currency area resul (fixed exchange raes are more cosly he less mobile is labor) bu wih a quie differen logic. Unlike he radiional case where labor mobiliy acs as a safey valve for unemployed workers, we explicily consider he welfare effecs of labor ransfers in he face of worker preferences oward locaional sabiliy. We find ha fixed exchange raes end o ransfer labor o high demand regions wihou aking full accoun of he coss of moving workers ha prefer o say a home. When we focus on supply shocks, however, we noe here are cases where he opimal currency area logic is reversed. Fixed exchange raes can preven highly mobile economies from fully realizing he efficiencies of moving workers o low cos producion areas. Thus, areas wih high iner-regional labor mobiliy benefi mos from exchange rae flexibiliy. JEL classificaion: F3, F4 Keywords: Labor mobiliy; Bayesian Esimaion; Welfare; Exchange Rae Regime; [email protected], [email protected]. We hank he Hong Kong Research Grans Council for suppor. We would like o hank paricipans a he IEFS China 21 conference for helpful commens and suggesions.

2 1 Inroducion Wha is he implicaion of labor mobiliy across counries for exchange rae regime choice of open economies? For a currency union like he euro zone, wha is he relaive welfare cos of a lower degree of labor mobiliy? Do he source of shocks maer? The opimal currency area heory (see Mundell, 1961) emphasizes he imporance of labor mobiliy for defining an opimum currency area. Facor mobiliy can help compensae for a lack of exchange rae re-alignmen in a currency union subjec o asymmeric shocks. If business cycle shocks are less han perfecly synchronized, free labor mobiliy wihin he union will help by moving workers from areas of srong o weak demand in he absence of relaive price adjusmen. In his paper, we explore he welfare implicaion of labor mobiliy in a New Keynesian model under differen exchange rae regimes. Modern sicky price models can provide a seing for a rigorous sudy of he coss and benefis of currency policy in open economies (see, for example Clarida, Gali, and Gerler, 22, and Beesma and Jensen, 25). To sudy his quesion, his paper proposes a wo region open economy sicky price dynamic sochasic general equilibrium (DSGE) model which feaures mobile labor supply across regions. The wo regions combine o form a poenial currency area, modeled as populaed by a single, represenaive household ha works in muliple locaions. The represenaive household views work in differen regions as imperfec subsiues and he elasiciy of subsiuion beween working in differen regions measures he degree of iner-regional labor mobiliy. Modeling he degree of labor mobiliy as a maer of preference is suppored by sudies such as Eser and Kriger (28), who argue ha greaer labor mobiliy in he U.S. relaive o Europe is due more o insiuional and culural facors han narrow economic consideraions. The model is used o make some quaniaive welfare comparisons of moneary policies. We find, consisen wih sandard logic (see Beningo and Beningno, 23, and Clarida e al. 22), ha flexible exchange raes are superior in welfare erms. 1

3 The key quesion ha we focus on is wheher he benefis of exchange rae flexibiliy are sronges for currency areas wih low labor mobiliy, in line wih sandard opimal currency area logic. In he face of demand shocks, currency areas wih immobile labor benefi he mos from flexible exchange raes as in sandard opimal currency area logic. In he face of supply shocks, he reverse is rue; areas wih mobile labor forces benefi he mos from exchange rae flexibiliy. Shocks which swich he relaive demand for regional goods lead o asymmeric labor allocaions. When i is cosly (in welfare erms or oherwise) o move labor across regions, reallocaion coss are refleced in regional real wage differenials. Nominal price rigidiies preven hese cos asymmeries from being immediaely refleced in relaive price levels. A benefi of flexible exchange raes (which we refer o as he worker preference benefi) is ha he coss of shifing workers across regions are refleced in relaive exchange raes minimizing inefficienly asymmeric misallocaions of labor. Fixed exchange raes in combinaion wih nominal rigidiies preven changes in relaive coss from being refleced in relaive prices resul in an overshifing of labor oward high demand regions wihou regard o he welfare cos of doing so. By conras, high labor mobiliy currency areas benefi grealy from flexible exchange raes in he face of produciviy shocks. Given perfecly mobile labor, he efficien oucome is o allocae labor oward high produciviy regions. Given sicky nominal prices, flexible exchange raes accelerae he speed wih which relaive prices reflec relaive produciviy levels, so demand ends o shif more quickly o he cheapes producer faciliaing he efficien reallocaion of resources. Fixed exchange raes, by conras, inhibi he efficien reallocaion of labor. We refer o he endency of flexible exchange raes o allocae labor o he high produciviy region as he produciviy benefi. When labor is less fully mobile, realizing he produciviy benefi of flexible exchange raes migh conflic wih worker preferences for locaional sabiliy and he overall benefi of flexible exchange raes is lower reversing he Mundell argumen. 2

4 Raher han infer preferences oward labor mobiliy from reduced form esimaes, we esimae key parameers of our model using Bayesian echniques (see Smes and Wouers, 23, 27; and Lubik and Schorfheide 25). Consideraion of opimal currency areas naurally leads o comparisons beween he Unied Saes, a longsanding currency union on he one hand, and he European Currency Area, a very new currency union on he oher. These wo coninenal currency unions differ along a number of obvious dimensions. Consisen wih he empirical findings from previous lieraures, Bayesian esimaes of he elasiciy of subsiuion of working in differen locaions is smaller in Europe han in US implying less labor mobiliy in Europe. We also find greaer subsiuabiliy of goods across regions in he Unied Saes. Our empirical findings are consisen wih previous work. Alhough boh currency unions allow for de jure free migraion of workers (see Heinz and Ward-Warmediger, 26, for a hisory of European labor marke deregulaion), subsanial empirical work suggess ha Americans are more geographically mobile beween regions han are Europeans. Benivogli and Pagano (1999) find ha regional migraion in he Unied Saes significanly responds o regional differences in income and unemploymen while i does no in Europe. Nickell (1997) poins ou ha greaer geographical mobiliy in he Unied Saes occurs in he conex of a greaer general level of job movemen. Some previous sudies (including OECD,1986; Sraubhaar, 1988; De Grauwe and Vanhaverbeke, 1993; and Gros, 1996) compare inerregional migraion wihin specific European naion saes wih inerregional migraion in he Unied Saes. Weidlich and Haag (1988), Eichengreen (1993), Barro and Sala-i-Marin (1995), Decressin and Faa (1995), Gros (1996b), McCormick (1997), he European Commission (1998), Puhani (1999) and Obsfeld and Peri (1998) have sudied he correlaion beween migraion flows and economic variables like wage and unemploymen differenials 1. 1 Previous research concludes ha he shock experienced by he European Union are more asymmeric han hose in he Unied Sae or in Germany (Bayoumi and Eichengreen, 1993; Funke, 1997), 3

5 Our paper is relaed o he opimal currency area lieraure on labor mobiliy. Several auhors quesion Mundell (1961) s emphasis on he imporance of labor mobiliy as a crierion for opimal currency area including McKinnon (1963), Kenen (1969), Grubel (197), and Corden (1973). 2 Recen heoreical conribuions on opimal currency area adop general-equilibrium framework based on microeconomic foundaions, hus allowing formal assessmen of various crieria of opimal currency area. These papers include Helpman(1981), Helpman and Razin (1982), Bayoumi (1994), Ricci (1997), and Neumeyer (1998). They usually focus on which fricion or rigidiies will affec a counry/region s choice among differen exchange rae regimes. However, few of hem discuss he labor mobiliy. One excepion is Bayoumi (1994) which presens a model wih regionally differeniaed goods in which wages are downwardly rigid. Each region can choose o have is own currency or join a union. Several ypical OCA facors are analyzed, including he size and correlaion of he disurbances, and he level of facor mobiliy across regions. He shows ha labor mobiliy lowers he coss associaed wih a currency union boh inside and ouside he union. And in he exreme case of perfec labor mobiliy, here are no oupu coss associaed wih forming a currency union in sharp conradicion wih our findings. This paper is organized as follows. Secion 2 describes he deails of he wo counry general equilibrium model. Secion 3 discusses he calibraion and Bayesian esimaion of model parameers. The impulse response funcions and he welfare comparison of differen exchange rae regime under differen labor mobiliy are discussed in Secion 4 and Secion 5, respecively. Secion 6 concludes he paper. where small counries are especially hi by asymmeric shocks (Buscher, 1999). 2 McKinnon (1963) and Kenen (1969) poin ou ha perfec inerregional mobiliy implies perfec occupaional mobiliy which is no possible. Grubel (197) argues Mundell s definiion of region is inapplicable o real world problems, because he does no disinguish beween differen degrees of labor mobiliy. Corden (1973) is skepical concerning he imporance of labor mobiliy in he adjusmen o asymmeric shocks because of insiuional and culural barriers. 4

6 2 The Model There are wo regions where goods are produced, specified as D and F, domesic or foreign. There is a single represenaive household which consumes a baske of differeniaed goods from each region. The governmen is assumed o se moneary policy, collec seigniorage, and rebae any surplus o households in lump-sum form. 2.1 Household The represenaive household maximizes E given by β U, where feliciy in period is U = C1 σ 1 σ ηh, σ > 1. (2.1) Consumpion, C, is a CES funcion of consumpion goods from each region, C = [ (b ) 1 α ( C D ) α + (1 b ) 1 α ( C F ) α ] 1 α (2.2) so 1 1 α is he elasiciy of subsiuion beween D produced consumpion goods, CD, priced a P D and F produced goods, C F, priced a P F and b is a relaive ase shock wih mean b. Cos minimizaion implies ha relaive demand for home and foreign produced consumpion goods follow C D = (b ) ( ) 1 P D P C α 1 C C F = (1 b ) ( S P F P C ) 1 α 1 C (2.3) where he consumer price index P C ( P C = (b ) ( P D is given by equaion: ) α α 1 + (1 b ) ( S P F ) α ) α 1 α α 1 (2.4) and S is he nominal exchange rae: he price of F currency in erms of D currency. Disuiliy from working is proporional o a funcion of work in each region, H. H = { D,F } 1 ϕ [H] l ϕ, ϕ 1 (2.5) l 5

7 where H l is he labor supply in region l. Work hours in differen regions are imperfec subsiues unless ϕ = 1 indicaing H D and H F are perfec subsiues. The elasiciy 1 of subsiuion of work in differen regions is. Hence, a higher ϕ implies a lower ϕ 1 degree of labor mobiliy across regions. The represenaive agen builds capial in each region, K l, hrough gross capial formaion, GCF l, according o he dynamic equaion K+1 l = (1 δ)k l + GCF l f l 2 (GCF δ) 2 K l l = D, F (2.6) where δ is he depreciaion rae and f is he coefficien of capial adjusmen cos. Aggregae invesmen (he sum of GCF D and GCF F ) like aggregae consumpion, is a CES funcion of D goods and F goods: Cos minimizaion implies K l D,F [GCF l ] = I = [ b 1 α (I D ) α + (1 b) 1 α (I F ) α] 1 α (2.7) l I D = b ( P D P I The price for invesmen goods is given by ( P I = b ( ) P D α ) 1 ( ) α 1 I I F S P F 1 α 1 = (1 b) I (2.8) P I α 1 + (1 b) ( S P F ) α ) α 1 α α 1 (2.9) Noe ha invesmen demand is no subjec o ase shocks. In he absence of ase shocks, P I = P C. In each period, he represenaive household will inves and own capial which hey ren o firms. The budge consrains is P C C + P I I + B D +1 + S B F +1 = W D H D + S W F H F + R D K D + R F K F + Π +(1 + i D )B D + (1 + i F )S B F + T AX (2.1) where B l and i l are, respecively, he holdings and ineres rae on bonds from region l in period ; W l is he wage in region l; T AX is he ransfer from governmen; and Π is he sum of profi earned by all firms wih marke power. 6

8 The firs order condiions for consumpion, bond holding and capial accumulaion are given below Λ l = βe [Λ l +1 Λ l (1 δ + Ω = 1 P C C σ [ ] 1 = βe (1 + i l ) Ωl +1 [1 f ( GCF l K l f2 (GCF l +1 K l +1 Ω l ] δ) (2.11) (2.12) = P I Ω l (2.13) δ)( GCF +1 l + δ) K+1 l ) ] + Ω l +1R+1 l (2.14) where Ω is he shadow value of income a ime and Λ l is he shadow cos of capial. Define Ω D = Ω and Ω F = S Ω.The supply of labor in each region is 2.2 Firms Reail Firms Ω l W l = η( Hl H ) ϕ 1 (2.15) Reail goods in region l, A l, are a uni measure of differeniaed wholesale goods, a l (i), produced here: C D + I D + G D = A D = C F + I F + G F = A F = 1 1 [a D (i) λ 1 λ [a F (i) λ 1 λ di] λ λ 1 di] λ λ 1 where λ > 1 is he elasiciy of subsiuion beween differeniaed wholesale goods. These reail goods are used for eiher household absorpion, or for region-specific invesmen and governmen expendiure absorpion. good based on he price of ha good, p l (i): There is a demand for each a l (i) A l ( ) p l λ = (i) (2.16) P l 7

9 2.2.2 Wholesale Firms A uni range of monopolisically compeiive wholesale firms ransform an undiffereniaed manufacuring good purchased a compeiive price, MC l. The wholesalers are only able o change heir nominal price wih a probabiliy (1 κ). The expeced discouned profis of a region l firm able o change heir prices a ime are max p l, [ E (βκ) τ Ω l +τ τ= Combining his wih he demand curve (??), we wrie: max p l [ E (βκ) τ Ω l +τa l +i τ= The firs order condiions: p l (i) = { p l (i) a l +τ(i) MC l +τ a l +τ(i) }] (2.17) ( P l +τ ) λ { p l (i) 1 λ MC l +τ p l (i) λ}] (2.18) [ ( ) ] λ E τ= (βκ)τ Ω l +τa l +i P l λ +τ MC l +τ [ λ 1 ( ) ] E τ= (βκ)τ Ω l +τa l +i P l λ +τ where p l (i) = p l across all differeniaed goods i. Due o he law of large numbers he price level evolves ( P l ) 1 λ = κ ( P l 1 ) 1 λ + (1 κ) ( p l ) 1 λ Producion Firms In each region he final goods are produced using a Cobb-Douglas producion funcion wih an exogenous region specific echnology shock, Z l The producer rens capial and hires workers Y l = Z l (K l ) θ (H l ) 1 θ (2.19) MC l Z l (k l ) θ (h l ) 1 θ W l H l R l K l (2.2) 8

10 So he firs order condiions are θmc l Z l (K l ) θ (H l ) 1 θ = R l (2.21) (1 θ)mc l Z l (K l ) θ (H l ) θ = W l (2.22) 2.3 Moneary Policy There is a cenral bank which considers wo possible policies. The firs ses independen ineres raes in eiher currency as a funcion of inflaion allowing for flexible exchange raes. i l = i l + ψ ( P l 1) (2.23) P 1 l where i l = 1 1 is he seady sae nominal ineres rae in region l. The second β policy regime is a currency union wih economy wide inflaion argeing. 2.4 Exernal Shocks S = 1 i = ( 1 β 1) + ψ ( P C 1) P 1 C Three kinds of shocks are inroduced. The region specific echnology shock, Z l, follows a AR(1) process: ln(z) l = ρ z ln(z 1) l + ε Z (2.24) where ε Z N(, σz). 2 The second region specific shock o governmen expendiure G l, also follows a AR(1) process wih persisence ρ g : ln G l = (1 ρ g ) ln G + ρ g ln G l 1 + ε G (2.25) 9

11 where ε G N(, σ 2 g). The sochasic process of he ase shock b is: b = (1 ρ b )b + ρ b b 1 + ε b (2.26) where ε b N(, σ 2 b ). 2.5 Equilibrium The demand for home and foreign goods comes from household consumpion, invesmen demand and governmen expendiure. From he marke clearing condiions of home and foreign goods, we have Y l = A l = C l + I l + G l (2.27) In a symmeric equilibrium, he domesic bond marke clearing implies ha B l =. Finally, he equilibrium of our model is defined as follows. 3 Given he sochasic process of he exernal shocks, Z l, b and G l and he moneary policy rule, an equilibrium is characerized by a collecion of 33 sequences: {C, C l, L, H l, Y l, K l, A l, GCF l, I l } and {P C, P I, P l, p l, W l, MC l, S, Ω l, Λ l, i l, R l }, such ha: (a) households opimally choose consumpion, bond holding, and labor supply; (b) boh wholesale goods firms and reail goods firms maximize profis; (c) home and foreign goods marke, capial goods marke labor marke, domesic bond marke, and foreign bond marke all clear. 3 Calibraion and Esimaion We calibrae a number of sandard business cycle parameers, seing β =.99, δ =.25, θ =.36 and ρ Z =.95 following Hansen (1985). The coefficien of risk 3 This flexible exchange rae regime model conains wo uni roos. So when solving his model, we normalize he model by dividing all he home nominal variables by P D, and foreign nominal variables by P F,. As o he fixed exchange rae regime model, we normalize all he nominal variables by aggregae consumpion price level P C. The deails of he normalized equilibrium condiions are given in he Technical Appendix. 1

12 aversion, σ is se o 2 4. The parameer characerizing he capial adjusmen cos, f = 3, so ha he elasiciy of he invesmen capial raio wih respec o Tobin s q is wihin he range suggesed by Bernanke, Gerler and Gilchris (1996). The elasiciy of subsiuion across individual wholesale goods, λ, equals 11, implying a seady sae markup of 1%. We se 1 κ, he possibiliy for wholesale firms o adjus heir prices, o be.75, so prices usually adjus on average afer four quarers. We se ψ = 1.5 for he moneary policy rules following Taylor. We se he seady sae share of governmen spending a.2 and ρ G =.9 following Gali, Lopez-Salido, and Valles (27). For symmery, we se ρ b =.9. Values of srucural parameers for he model are described in Table??. We esimae he fixed exchange rae model using Bayesian mehods (see Smes and Wouers, 23, 27; Lubik and Schorfheide 25, and Dong, 212) and daa from regions of he US and European Moneary Union o derive values of α and ϕ (see unpublished Appendix). Each economy can be considered a common currency area. Since our model seing feaures a wo-region framework, we divide each economy ino wo regions. We choose he se of counries/saes in each region such ha he aggregae GDP of counries (saes) in each region is roughly he same. In he case of he US, we combine wo Census regions, Souh and Norh-Cenral ino one region, and combine Wes and Norh-eas Census regions ino anoher. 5 The sample period for he 4 I should be noed ha he uiliy funcion in his paper (separable beween consumpion and leisure) is inconsisen wih balanced growh under he calibraed value of σ = 2. However, in his paper we focus on he shor run dynamics around he seady sae insead of balance growh pah, so non-separabiliy should no be a criical issue. Also, his uiliy funcion is used exensively in he new open economy macroeconomic lieraure. See, for example, Obsfeld and Rogoff (22), Chari, Kehoe and McGraan (22), Devereux and Engel (23), and Devereux, Lane and Xu (26). 5 According o he Regional divisions used by he Unied Saes Census Bureau, Norheas includes Maine, New Hampshire, Vermon, Massachuses, Rhode Island, Connecicu, New York, Pennsylvania, and New Jersey. Midwes (Norh Cenral Region) includes Wisconsin, Michigan, Illinois, Indiana, Ohio, Missouri, Norh Dakoa, Souh Dakoa, Nebraska, Kansas, Minnesoa, and Iowa. Souh includes Delaware, Maryland, Disric of Columbia, Virginia, Wes Virginia, Norh Carolina, Souh Carolina, Georgia, Florida, Kenucky, Tennessee, Mississippi, Alabama, Oklahoma, Texas, Arkansas, and Louisiana. Wes includes Idaho, Monana, Wyoming, Nevada, Uah, Colorado, 11

13 US daa is from 198.Q1-28.Q2. 6 For he Euroland, we consider wo sample periods. One sample period is from 1999.Q1-28.Q2, since he common currency in Economic and Moneary Union (EMU), Euro, is launched in Anoher sample period is from 1985.Q1-28.Q2, which also includes he European Moneary Sysem period 7 prior o he launch of Euro in Since he EMS represens an exchange rae sysem based on fixed pariies wih bands, we can rea his period as a fixed exchange rae regime in Euroland. The counries included in each region are slighly differen under he wo sample periods. For he firs sample period (1999.Q1-28.Q2), Region 1 includes France, Ialy, Spain, Porugal and Greece, while Region 2 includes Ausria, Belgium, Finland, Germany, Ireland, and Neherlands. In he second sample period, Region 1 includes only France, Ialy, Spain, and Porugal, and Region 2 only Ausria, Finland, Germany, and Neherlands. Our bes esimae for he labor mobiliy parameer in he US is ϕ 2 while in he EMU ϕ 6. We esimae ha he elasiciy of goods across locaions is bes represened by α =.9 in he US and α =.75 in he Eurozone. These esimaes are higher han many used in macro-sudies such as Backus, Kehoe and Kydland (1992). 8 Given ha our esimaes represen inra-economy subsiuion, higher sub- Arizona, New Mexico, Alaska, Washingon, Oregon, California, and Hawaii. 6 In his paper we would like o use he comovemen of differen regions o idenify he labor marke fricions. So we focus on he period ending prior o he financial crisis of 28 during which conemporaneous comovmen beween European counries (US saes) was high. Cook and Devereux (211) show ha inernaional comovemen is quie differen a he zero lower bound han a normal imes. 7 In 1979, he European Council (EC) adoped he European Moneary Sysem, known as EMS, which employed an exchange rae mechanism, or ERM, o encourage paricipaing counries o keep he flucuaions of heir currency exchange raes wihin an accepable band. The permissible limis of he ERM were derived from he European Currency Uni, or ECU, a referenial currency calculaed from an average of he paricipaing counries naional currencies. We choose he sample o sar from 1985 since several member counries, such as Spain and Porugal, joined EC in For example, Lubik and Schorfheide (25) repors esimaes of elasiciy of subsiuion o be.43 o fi daa for he US and Euro area. In Dong(212), he esimaed elasiciy is beween 1.13 o

14 Table 1: Parameers used in he IRF and Welfare comparison Parameers value Parameers value σ 2 β.99 δ.25 λ 11 η 1 f 3 κ.75 a.5 θ.36 ψ 1.5 Parameers Esimaed value Shock Process value ϕ 2, 6 ρ z.95 α.75 ρ g.9 σ z, σ g, σ b.1 siuabiliy expeced. Furher micro sudies ypically find much higher esimaes of he rade elasiciy of subsiuion, usually in he range of 5 o 6 (see, for example, Lai and Trefler, 22); our esimaes for he EMU lie in his range. In ligh of hese esimaes and our desire o focus on he impac of inraregional labor mobiliy, we use α =.75 as a benchmark and examine he effecs of exchange rae choices under alernaive moneary policies considering he couner-facual alernaive of inraregional exchange rae flexibiliy. 4 Impulse Response Funcions In his secion, we consider he dynamic impac of independen regional echnology, governmen spending and ase shocks. Comparing he effecs of independen shocks highlighs he effecs of business cycle asymmery. 13

15 4.1 Technology Shocks Panel A of Figures 1 and Figure 2 show he response of he economy o a posiive domesic produciviy shock (Z D ) under differen degrees of labor mobiliy. Figure 1 shows he response of aggregae variables while Figure 2 shows he response for region-specific variables. To a firs approximaion, aggregae oucomes are deermined by he average of world moneary policy which is equivalen under he fixed and floaing exchange rae regimes. The aggregae consumpion response o echnology is unaffeced by he choice of moneary policy or he degree of labor mobiliy beween secors. I is he relaive level of employmen and producion across regions ha depends on he exchange rae flexibiliy allowed by moneary policy. Figure 2 shows he regional allocaion of labor under flexible exchange raes. The domesic produciviy shock should reduce he relaive cos of producing in economy D. Flexible exchange raes allow hese lower relaive coss o be refleced in lower relaive prices hrough nominal depreciaion. In he high labor mobiliy U SA specificaion, he equilibrium response is o shif producion and consumpion oward he low cos domesic economy. The demand for cheaper domesic goods implies a shif of workers oward he domesic economy and away from he foreign economy. As jobs in each economy are good subsiues, his re-allocaion can occur wihou a large shif in relaive wage so he cos advanage of he D economy is mainained. Thus, H D increases following he shock while H F decreases. The oucome is quie differen in he low labor mobiliy EU specificaion. Here, working hours in differen locaions are imperfec subsiues. To shif labor away from he foreign economy oward he domesic economy requires an increase in domesic wages relaive o foreign wages which would limi he cos advanage of he domesic economy. In equilibrium, employmen in boh regions will rise relaively evenly. The regional allocaion of labor is very differen under fixed exchange raes. Under sicky prices and fixed exchange raes, he relaive price of domesic and foreign goods 14

16 responds only slowly o a shock ha makes producion relaively cheaper in he domesic economy. Relaive demand for regional goods will, hus, change only as sicky nominal prices change. Since producion is demand driven, he level of oupu in each secor will say relaively balanced. Since he high produciviy domesic secor needs less labor o mee his demand, labor is reallocaed away from he producive region and oward he less producive foreign region. The shor-run shif of labor o he low produciviy region occurs under boh he U SA and he EU specificaion since labor mobiliy (and, hus, relaive labor coss) has lile impac on he relaive demand in he shor-run. When prices adjus, several periods afer he shock, labor reallocaes back oward he medium run allocaion generaed under he flexible exchange rae equilibrium. Under he U SA specificaion, employmen paerns reverse and labor in he high produciviy region urns posiive while labor in he low produciviy region urns negaive. Under he EU specificaion, employmen shifs oward a more even allocaion of labor and we observe above seady sae levels of employmen in boh regions. 4.2 Governmen Spending Shocks Panel B of Figure 1 repors he impulse responses of he aggregae economy o a posiive exogenous domesic governmen spending shock, G D, financed by nondisorionary axaion on he represenaive agen. Aggregae governmen spending will creae a negaive income shock, increasing aggregae labor and reducing privae consumpion. Figure 3 repors he regional allocaion. Any single region faces shor-erm increasing marginal coss due o quasi-fixed capial. When domesic goods producion is shifed o governmen expendiure, he marginal cos of producing consumpion and invesmen goods in he domesic region increases. Under flexible exchange raes, his leads o an increase in he relaive price of domesically produced goods. Relaive demand for domesic region consumpion and invesmen goods falls. Labor 15

17 increases in boh regions as producion is direced oward governmen consumpion in he domesic region and oward privae consumpion and invesmen in he foreign region. Under he high labor mobiliy U SA specificaion, labor shifs slighly oward he domesic economy. Under he low labor mobiliy EU specificaion, shifing labor oward he domesic region would require higher relaive wages inducing higher relaive prices which would, in urn, shif privae demand oward he foreign region. In equilibrium, he employmen increase is slighly more even han under low labor mobiliy. The shor run allocaion of labor is differen under fixed exchange raes. Due o sicky prices and fixed exchange raes, he higher marginal cos of producing goods in he domesic region following he governmen spending shock is no immediaely fel in erms of increased relaive prices. Thus, household consumpion and invesmen demand do no shif as much oward he foreign region as is he case under flexible exchange raes. Domesic oupu and employmen increase significanly more under fixed exchange raes han under flexible raes. Similarly, relaive demand for foreign goods does no increase as much under fixed as under flexible exchange raes. In he shor run, employmen and oupu expand more slowly in he foreign region under fixed raes. The degree of preference oward labor mobiliy has less impac on he shor run allocaion under fixed exchange raes since he wage differenials needed for asymmeric labor allocaions do no pass hrough o relaive prices. 4.3 Tase Shocks Figure 1, Panel C shows he response o a persisen ase shock which shifs demand oward he domesic economy. If he facors of producion could shif fricionlessly oward he favored region, he efficien response of he economy would no change aggregae allocaions. However, he facors of producion canno shif so quickly due o imperfec labor mobiliy and capial adjusmen coss. A ase shif unmached by a shif of producion reduces he consumpion aggregae. The decline in consumpion 16

18 increases he marginal uiliy of income increasing labor supply. The increase in equilibrium employmen increases invesmen. However, all of he aggregae effecs are small. Figure 4 describes he regional reallocaion in response o an increase in ase for consumpion of domesic produced goods. In each case, C D, increases persisenly while, C F, persisenly declines. To suppor his, he economy can adjus along a number of margins: 1) employmen shifs from he foreign region o he domesic region; 2) capial formaion shifs from he foreign region o he domesic region; and 3) producion of invesmen goods shifs from he domesic region o he foreign region. However, he degree of adjusmen depends on boh he degree of labor mobiliy and moneary policy. To shif labor across regions in he face of workers preference for labor symmery requires an increase in wage differenials. To he degree ha wage cos differenials are refleced in relaive prices, he equilibrium increase in consumpion of he favored good will be empered by he rise in is relaive price. In he low labor mobiliy EU specificaion, larger wage differenials are needed o implemen any given asymmeric labor allocaion. Thus, here are smaller equilibrium shifs in regional labor, oupu and consumpion in he EU specificaion han he U SA specificaion. The swich o foreign produced invesmen goods is hus greaer when labor mobiliy is low. Exchange rae policy has a srong effec on equilibrium allocaions. The wage differenials needed o compensae labor for shifing o he domesic region can only parially pass hrough o prices. Under flexible exchange raes, he domesic currency appreciaes so ha relaive regional prices reflec relaive coss. The rise in he relaive price of domesic goods aenuaes he shif in ase in domesic goods. Under fixed exchange raes, he coss of shifing workers is no immediaely fel in he relaive price of buying domesic goods. The rise in domesic consumpion, C D, is much larger under fixed exchange raes han under flexible exchange raes. To saisfy his demand, he shif in labor o he domesic region and he increase in domesic oupu 17

19 is larger under fixed raes han flexible raes. 5 Welfare Impac We measure welfare under differen policies using he condiional expeced lifeime uiliy of he represenaive household a ime zero, V = E [ β U ]. To compare he magniude of welfare differences across differen regimes, we define cl k as he percenage change of deerminisic seady sae consumpion ha will give he same condiional expeced uiliy, V k, under regime k. Tha is: U( C + C k, L) 1 β = V k, cl k = C k, k = fix, flex (5.28) C where a bar over a variable denoes he deerminisic seady sae of ha variable. If cl k > (< ), he welfare under regime k is implied o be higher (lower) han ha of he seady sae case. Higher values of cl k correspond o higher welfare. Welfare, V k, is compued by aking second-order Taylor approximaions of he srucural equaions around he deerminisic seady sae. Table?? repors he welfare resuls for independen ase shocks, independen echnology shocks and independen governmen spending shocks, each of equal size, σ b = σ z = σ g =.1. We examine he benefis of exchange rae flexibiliy, defined as cl F LEX cl F IX. We repor cl under differen levels of ϕ from 1 o 8, which spans perfec labor mobiliy o a level of immobiliy greaer han we esimae for Europe.Given sicky prices in each region, flexible exchange raes allow relaive regional prices (i.e. he real exchange rae) o reflec movemens in relaive marginal coss. This more closely resembles he flexible price oucome, so cl F LEX cl F IX is generally posiive. Our focus is on examining wheher he benefis of exchange rae flexibiliy are larges for economies wih greaer degrees of labor immobiliy in line wih sandard opimal currency area heory. On his accoun, our resuls differ depending on he ype of 18

20 Table 2: Welfare Resuls (in %) Labor Fixed ER Flexible ER Welfare Difference Mobiliy cl F IX cl F LEX cl F LEX cl F IX Technology Shock ϕ = ϕ = ϕ = ϕ = ϕ = ϕ = ϕ = Governmen Expendiure Shock ϕ = ϕ = ϕ = ϕ = ϕ = ϕ = ϕ = Tase Shock ϕ = ϕ = ϕ = ϕ = ϕ = ϕ = ϕ =

21 shocks. To illusrae his, we repor cl F LEX cl F IX focusing on hree differen ypes of shocks, each one, in urn, being he sole source of volailiy. 5.1 Tase Shocks Firs, we consider he welfare effecs of ase shocks, b. Tase shocks reallocae consumpion demand across regions. If all facors of producion could be reallocaed coslessly across regions, his would have no welfare effec. However, even absen preferences oward he locaion of work (i.e. ϕ = 1), capial adjusmen coss imply diminishing reurns o labor in any region. A greaer ase for goods from one region will increase he marginal cos of producing here. Even given flexible prices, he increasing cos of favored region goods would preven consumpion allocaions from maching he ase shif and he uiliy of consumpion spending would decline. This negaive effec of realized ase shocks is refleced in negaive levels of cl a all specificaions. Sicky prices furher disor allocaions since he increasing producion coss of swiching oward a favored region will no be fully refleced in he nominal prices of goods. Under fixed exchange raes, relaive regional prices (i.e. he real exchange rae) will only slowly reflec he relaive regional coss. As a resul, relaive expendiure will respond o ase shocks by over-shifing oward favored bu high cos regions. By conras, exchange rae flexibiliy allows a more rapid adjusmen of relaive prices prevening he over-shifing of demand and producing an oucome more similar o flexible prices. This illusraes one key benefi of exchange rae flexibiliy ha we refer o as he produciviy benefi; flexible exchange raes allow relaive prices o reflec differences in labor produciviy (producion cos) and encourage allocaion of labor oward regions where labor produciviy is higher (producion cos is lower). However, his produciviy benefi is relaively small. When ϕ = 1, cl F LEX cl F IX is a is smalles. There is an addiional welfare cos of ase shocks when labor is less perfecly 2

22 mobile (i.e. when ϕ > 1). The household has a preference for symmeric labor allocaion across regions. Tase shocks which swich demand o a favored region can only be saisfied by shifing labor oward ha region. This raises he disuiliy coss of working. The greaer is ϕ, he more inense is he negaive welfare effec of any given asymmeric allocaion of labor. For eiher exchange rae regime, cl is more negaive when ϕ is larger. There is anoher key benefi of exchange rae flexibiliy which we refer o as he worker preference benefi. Firms mus pay excess wages o arac labor oward a paricular region when workers prefer symmery. Under fixed exchange raes, ase shocks lead o an overshif in demand oward he favored region, since relaive prices don reflec he higher wage coss needed o relocae immobile labor. The overshif in demand will lead o inefficienly asymmeric labor allocaions. Under flexible exchange raes, he currency of a favored region appreciaes o reflec he higher wage coss, limi demand for he favored regions goods, and keep labor more even across regions. The degree of labor immobiliy enhances he benefis of flexible exchange raes. When ϕ is high, he welfare coss of he asymmeric labor misallocaions due o fixed exchange raes are high. Therefore, he worker preference benefis of flexible exchange raes will be larger for currency areas wih immobile labor. The higher is ϕ, he higher is cl F LEX cl F IX, consisen wih he radiional ideas of he opimal currency area. Bu as explained above, he logic is quie differen. Unlike he radiional case where labor mobiliy acs as a safey valve for unemployed workers, we explicily consider he welfare effecs of immobiliy coss associaed wih worker preferences oward locaional sabiliy. 5.2 Technology Shocks When he economy is faced wih only echnology shocks, he uncondiional expecaion of welfare is, perhaps surprisingly, higher han he seady-sae. As Cho and Cooley (1995) show, his oucome can be a resul of he inrinsic increasing reurns o 21

23 scale naure of producion involving boh opimal labor and echnology. This effec is magnified when employmen can easily shif o a high echnology region. Typically, he produciviy level in he highes produciviy region will be higher han seady sae. Since mobile labor will end o concenrae in he high produciviy region, he aggregae labor force will end o be working a a higher produciviy locaion han he seady sae level. This makes volailiy in he produciviy of differen locaions advanageous: cl is posiive for all specificaions. Focusing on he full labor mobiliy case where ϕ = 1, we clearly see he produciviy benefi of flexible exchange raes in he face of echnology shocks. Under flexible exchange raes, he relaively high produciviy/low cos region will experience real depreciaion, shifing demand o his region o he degree ha exra labor is shifed oward he high produciviy producer. Under fixed exchange raes, by conras, he real depreciaion and consequen shif in demand is smaller and slower. The shif in demand oward he high produciviy region is sufficienly small ha workers iniially shif oward he less producive regions. When ϕ > 1, workers have a preference for symmeric employmen and eiher moneary policy will implemen a more symmeric equilibrium allocaion of labor han when ϕ = 1. Symmeric allocaions may conflic wih aking full advanage of asymmeric produciviy. This reduces he produciviy benefi of flexible exchange raes, bu he worker preference benefi will sar o play a role. Labor immobiliy is represened as a worker preference oward even employmen across regions. Though boh fixed and flexible exchange raes implemen uneven employmen a ϕ = 1, he employmen asymmery is, in fac, larger under flexible raes (wih flexible rae economies biased oward he producive region and fixed rae economies biased oward he less producive one). When ϕ is slighly above 1, flexible exchange raes have a negaive worker preference benefi due o he greaer asymmery of employmen. Thus, when ϕ is slighly above 1, he welfare gap cl F LEX cl F IX is narrower han when ϕ is exacly equal o 1. 22

24 The oal benefi of flexible exchange raes, cl F LEX cl F IX, is highes under perfec labor mobiliy, he opposie of he usual currency area logic. However, he relaionship beween he benefis of a flexible exchange rae and he degree of labor mobiliy is non-monoonic. When ϕ is small, he produciviy benefi is relaively large, and he worker preference benefis is relaively small. So he welfare gap, cl F LEX cl F IX, is mainly deermined by he produciviy benefi of exchange rae flexibiliy, which is highes under perfec labor mobiliy (ϕ = 1). When labor mobiliy is less perfec a higher levels of ϕ, efficien allocaions of labor are more symmeric (even wih produciviy differenials). A flexible exchange rae comes closer o implemening hose efficien allocaions as relaive prices reflec he wage differenials needed o shif workers across regions. The worker preference benefis of exchange rae flexibiliy increases wih ϕ and evenually dominaes he welfare gap when ϕ is sufficienly large. This endency of flexible exchange raes o reflec worker preferences oward symmery which are srong when ϕ is large leads cl F LEX cl F IX o be larger for currency areas wih very immobile work forces han for inermediae cases. In our simple model, he welfare benefi of flexible exchange raes in he US specificaion wih ϕ =2 is similar in size o he benefis in he EU specificaion wih ϕ = 6. The above resuls depend on he degree of subsiuabiliy of regional goods, α, which governs he degree o which i is opimal o swich producion o high produciviy regions. In Table 3, we repor he welfare effecs under echnology shocks when α =.9 as we esimae for he US economy. When goods are close subsiues, efficien swiching of demand o high produciviy/low cos regions is large. A α =.9, he elasiciy of subsiuion is as high as 1 creaing very asymmeric efficien allocaions of labor when ϕ = 1. This implies ha, wih highly subsiuable goods, he produciviy benefi of exchange rae flexibiliy is also larger. The welfare gap beween flexible and fixed exchange rae will be dominaed by he produciviy benefi. The produciviy benefi decreases wih ϕ since aking full advanage of he produciviy 23

25 benefi of flexible exchange raes conflics wih worker preferences. When worker preferences oward even allocaion are srong (i.e. for larger levels of ϕ), cl F LEX cl F IX is smaller. This is opposie o he predicion of sandard opimal currency area heory. In he case where regional goods are less perfec subsiues, here are no srong gains from shifing labor o he mos producive region since he good produced here would have diminishing reurns in consumpion. For symmery, we consider he case where α =.6, so elasiciy of subsiuion is 2.5. The produciviy benefis of exchange rae flexibiliy are smaller; expeced uiliy is only marginally greaer han he non-sochasic seady sae allocaion under flexible exchange raes. Under fixed exchange raes, welfare is smaller han he seady sae when ϕ is large enough (greaer han 4) as he fixed exchange rae creaes a misallocaion of labor o low produciviy regions. When ϕ = 1, he labor allocaion under flexible exchange raes is less asymmeric han he allocaion under fixed exchange raes. Since he relaively symmeric allocaion is more in line wih worker preferences, he produciviy benefi aligns wih he worker preference benefi. The relaive coss of he misallocaions of labor under he fixed exchange rae regime increase when labor sabiliy is preferred; cl F LEX cl F IX increases as ϕ rises. When α is small, we ge similar resuls abou he relaionship beween labor mobiliy and relaive benefis of flexible exchange raes under echnology shocks as under ase shocks, in line wih he usual currency area logic. 5.3 Governmen Spending Shocks We also consider he welfare effecs of governmen spending shocks under fixed and flexible exchange raes wih differen degrees of labor mobiliy. Volailiy of he spending on lump sum goods has a negaive effec on welfare. Table?? shows ha cl k is always negaive. As shown in Figures 1 and 3, he income effecs of governmen spending shocks in any region increase labor supply in boh regions. Flexible exchange rae policy implemens relaively even levels of employmen by shifing privae secor 24

26 demand oward he region no facing he fiscal shock. In his model, fixed exchange raes creae disorions of employmen away from he efficien allocaion of goods and he even allocaion of labor. Thus, fixed exchange raes have negaive impacs on welfare and cl F LEX cl F IX is always posiive. As in he case of ase shocks, he produciviy benefi of flexible exchange raes comes from he endency o miigae he overshifing of labor o regions experiencing diminishing reurns. The worker preference benefi of flexible exchange raes is mos pronounced when labor is very immobile. Thus as ϕ increases away from 1, he benefis of flexible exchange raes increase. 6 Conclusion We sudy labor mobiliy in a model wih sicky prices bu perfecly compeiive labor markes. There may be alernaive ways of hinking abou labor immobiliy oher han a preference for locaional sabiliy. Labor immobiliy migh be modeled as a echnological barrier or as search fricions (along he lines of Morensen and Pissarides, 1994). I would be ineresing o examine he welfare effecs of exchange rae regimes in hese circumsances. 25

27 Table 3: Welfare Resuls of Supply Shock (in %, changing α) Labor Fixed ER Flexible ER Welfare Difference Mobiliy cl F IX cl F LEX cl F LEX cl F IX α =.6 ϕ = ϕ = ϕ = ϕ = ϕ = ϕ = ϕ = ϕ = α =.75 ϕ = ϕ = ϕ = ϕ = ϕ = ϕ = ϕ = ϕ = α =.9 ϕ = ϕ = ϕ = ϕ = ϕ = ϕ = ϕ = ϕ =

28 Figure 1: Impulse Response o home (US) shocks: Aggregae Variables Panel A: Consumpion o T shocks Panel B: Consumpion o G shocks Panel C: Consumpion o Tase shocks Labor Disuiliy o T shocks Labor Disuiliy o G shocks Labor Disuiliy o Tase shocks Invesmen o T shocks Invesmen o G shocks Invesmen o Tase shocks 1 φ=2, FLE φ=6, FLE φ=2, FER φ=6, FER 27

29 Figure 2: Impulse Response o + home echnology shock: Regional Variables C D, o T shocks C F, H D, H F, I D I F GCF D GCF F D F Relaive Wage W /(S W ) Real Exchange Rae Y D, Y F, φ=2, FLE φ=6, FLE φ=2, FER.1 φ=6, FER

30 Figure 3: Impulse Response o + gov. expendiure shock: Regional Varialbes C D, o G shocks C F, H D, H F, I D I F GCF D GCF F D F Relaive Wage: W /(S W ) Real Exchange Rae Y D, Y F, φ=2, FLE.4.2 φ=6, FLE φ=2, FER.15 φ=6, FER

31 Figure 4: Impulse Response o ase shock for home goods: Regional Varialbes C D, o Tase shocks C F, H D, H F, I D I F GCF D GCF F D F Real Exchange Rae Relaive Wage: W /(S W ) Y D, Y F, φ=2, FLE φ=6, FLE φ=2, FER φ=6, FER 3

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37 Appendix: No for Publicaion 1 Esimaing he Model A subse of he deep srucural parameers of he model will be esimaed wih Bayesian echniques following Smes and Wouers (23, 27) and Lubik and Schorfheide (25). Of paricular imporance among he esimaed parameers are hose deermining he degree of labor mobiliy and he degree of goods subsiuabiliy. We joinly esimae hese parameers along wih he parameers governing he sochasic processes. 1.1 Daa As described in he paper, we divide he EU counries ino n = 1, 2 regions. The regional aggregaes are he sum of daa from he counries assigned o he region. We consruc daa for seasonally adjused, quarerly real GDP, Y ; employmen, L ; and consumpion, C. 9 To idenify he parameers, he vecor of observed variables, Z, includes he growh raes of regional GDP and employmen and he firs difference of he log raio of regional consumpion. Daa is from OECD Quarerly Naional Accouns and Main Economic Indicaors daabases. EU1 ḡ y ln Y EU1 dly EU1,2 EU2 ḡ Z EU = dll EU1,2 y ln Y EU2 = EU1 ḡ l + ln L EU1 EU2 dlcrat ḡ l ln L EU2 ḡcrat EU ln CEU2 C EU1 ln Y EU1 1 ln Y EU2 1 ln L EU1 1 ln L EU2 1 ln CEU2 1 C 1 EU1 (1.1) where dl sands for 1 imes log difference; ḡ y, ḡ c, and ḡ l are he quarerly rend growh rae of real GDP, consumpion and employmen, respecively. 9 There are five shocks in he esimaed model. So o avoid he use of measuremen error, we use wo GDP, wo employmen, and he relaive consumpion (home consumpion / foreign consumpion) when esimaing he Euroland mode. 1

38 For he US, we have sae level measures of employmen and employmen compensaion which we use as a proxy for GDP 1. Since we use he US sae level employmen compensaion as he proxy for sae level GDP, we assume ha ime series for employmen compensaion conains a measuremen error. Formally, he corresponding measuremen equaion is: Z EU = ( dly US1,2 dll EU1,2 ) = ḡ y EU1 ḡ y EU2 ḡ l US1 ḡ l US2 + ln Y EU1 ln Y EU2 ln L EU1 ln L EU2 ln Y EU1 1 ln Y EU2 1 ln L EU1 1 ln L EU2 1 where ε me y, represens he measuremen error for he US real GDP. + ε me y1, ε me y2, (1.2) 1.2 Prior Disribuion Generally, for prior densiies, Bea disribuions are chosen for parameers ha are consrained in he uni inerval; Gamma disribuions are chosen for parameers defined o be non-negaive and inverse Gamma disribuion are seleced for sandard deviaion of shocks. In his paper, he prior disribuion of parameers are se o be he same for he wo regions and over differen sample periods. An overview of he prior disribuion for he parameers are specified in Tables 1 and 2. Specifically, he parameer ha characerizes he elasiciy of subsiuion of working in differen counries, ϕ, is assumed o have a Gamma disribuion wih mean 4 and sandard deviaion 1. This prior disribuion implies ha he elasiciy of working in differen locaions ceners around.33. The prior disribuion of α, he parameer characerizing he elasiciy of subsiuion beween home and foreign consumpion goods, is assumed o be uniform wih a mean of.5 and a suppor of [, 1]. This implies an elasiciy of subsiuion beween home and foreign consumpion goods 1 There are no daa available for real GDP and consumpion a he Sae level. So we use he US sae labor compensaion as he proxy for sae GDP. 2

39 equal o 2. These wo parameers are imporan since we focus on he esimaion of labor marke fricion and oupu comovemen. For he exogenous shocks, we assume he sandard errors σ d, σ f, σ g d, σ g f, σ ε muliplied by 1, have an inverse-gamma prior disribuion wih a mean of 1 and a sandard deviaion of infiniy, which corresponds o a raher loose prior. We assign Bea disribuions o he persisence of he exogenous shocks wih mean.9. The prior sandard deviaion of ρ d, ρ f, and ρ ε (persisence of echnology shocks and ase shock) are.5, while he prior sandard deviaion of persisence of he governmen expendiure shocks is Poserior esimaion Resuls Poserior parameer esimaes are repored in Table 1 and Table 2. Table 1 gives he esimaion resuls using he Euroland daa as he observable for each sample period, while Table 2 gives he resuls using he US daa as he observable. ables presens he poserior mean and he 95% confidence inerval of he poserior disribuion obained by suing he Mone Carlo Meropolis Hasings algorihm. I is subjec o 1,, draws, and he firs 5, draws are dropped. The parameer ha characerizes he elasiciy of subsiuion of working in differen counries/regions, ϕ, is esimaed o be around 5.1 and 5.83 for Euroland in and , respecively. This parameer is esimaed o be smaller for he US, wih a poserior mean of Afer modelling measuremen error, he esimaed ϕ for he US is even smaller, wih a poserior mean of This implies ha he elasiciy of subsiuion of working in differen locaions is around for Europe. For US, he implied elasiciy is higher, cenered around.355 for he non-measuremen error case and.86 for he case wih measuremen error. In oher words, he mobiliy of labor across differen counries in Europe is smaller han ha across differen saes in he US. This is consisen wih he well known facs de- 11 We also use esimae he model using four daa series, he home and foreign oupu and he home and foreign employmen. The poserior esimaes for ϕ is 4.97 in and 5.19 for The 3

40 scribed in OECD (1997), Decressin and Faàs(1995), Nickell (1997), and Layard and Nickell (2) ha labor mobiliy in erms of fracion of populaion movign from one region o anoher is much lower in some European counries han in he US. Several auhors, such as Berola and Ichino (1995) and Wasmer (24), show ha differen labor mobiliy is a key facor as a, perhaps, imporan cause of he diverging experiences of US and Europe in he unemploymen, wage dispersion and he response of oupu and employmen o macroeconomic shocks. The poserior disribuion of α in he Euroland has a mean of.7547 in he sample, and.4994 in he sample 12, which implies an elasiciy of subsiuion across domesic and foreign consumpion goods approximaely equal o 4 and 2, respecively. The esimae of he parameer α in he US is much higher, wih a mean of.89(.95), implying an elasiciy of subsiuion across consumpion goods in differen regions o be around 1(2). In he lieraure, he macro esimaes for he elasiciy of subsiuion beween economies (such as in Backus, Kehoe and Kydland, 1991 is in he range of.43 o 2. Micro rade sudies, however, find much higher esimaes of he rade elasiciy of subsiuion, usually in he range of 5 o Our esimaes for he EU counries are in he range of esimaes in he lieraure. Regarding he esimaes of he US counerpar, since he elasiciy of subsiuion is inraregional, i is reasonable ha he elasiciy will be much higher. The poserior esimaes of he persisence and sandard error for he exogenous shocks lie wihin he ranges of values in pervious empirical sudies. All he exogenous shocks are esimaed o be quie persisen across differen sample periods and in boh US and Euro area. The echnology shocks and he ase shock are more persisen han he governmen expendiure shock, alhough hey have he same prior disribuions. The poserior modes of sandard deviaions of innovaions do no vary much in magniude, ranging from.6 o If only oupu and employmen daa are used, he poserior mean of α equals.756 in and.5997 for See for example, Lai and Trefler (22). 4

41 2 Model assessmen Nex, o evaluae he performance of he model, we compare he second momens of oupu, labor, invesmen and consumpion of he simulaed model using he esimaed ϕ and α wih hose of he EU daa. The firs wo columns of Table 3 repor he sandard errors and cross-correlaions of he daa, and he nex few columns give hose of he model simulaed using he poserior mean lised in Table 1. We can see ha he model does no do paricularly well in maching he volailiy of he oupu as we may no cover a comprehensive se of shocks. Neverheless, given he esimaed and calibraed parameers, he model did a good job in maching he relaive volailiy of major macroeconomic variables. Also, he model canno fi he comovemen beween home and foreign oupu observed in he daa (which is a persisen puzzle in he lieraure). Sronger correlaion in he echnology shocks may be necessary o generae more comovemen of he oupu beween wo regions in he Euroland and he US. Finally i should be noed ha he model predics negaive comovemen beween home and foreign consumpion. This is because of he presence of ase shocks. A posiive ase shock o home consumpion goods implies a negaive ase shock o foriegn consumpion goods. Table 3 repors a comparison of he simulaion and available daa for he US. Unforunaely, daa limiaions allow us o look only a he second order momens relaed o oupu and labor. We see ha he simulaed model for he US does well in maching he correlaion beween oupu and labor, and relaive variance of he labor o he oupu. Again he model canno mach he comovemen of labor and oupu across wo regions wihou sronger echnology shock correlaion. 5

42 Table 1: Srucural Parameers and Shock Processes Esimaion(Euroland) Prior Disribuion Poserior Disribuion Poserior Disribuion Parameers Disr. Mean S. Dev. Mode Mean 5 percen 95 percen Mode Mean 5 percen 95 percen ϕ Gamma α Uniform ρd Bea ρf Bea ρ d g Bea ρ f g Bea ρε Bea σd Invgamma 1 Inf σf Invgamma 1 Inf σ g d Invgamma 1 Inf σ g f Invgamma 1 Inf σε Invgamma 1 Inf Noe: Invgamma indicaes ha 1 imes he parameers has a Inverse Gamma prior disribuion. 6

43 Table 2: Srucural Parameers and Shock Processes Esimaion(US) Prior Disribuion Poserior Disribuion (w/o ME a ) Poserior Disribuion (w/ ME) Parameers Disr. Mean S. Dev. Mode Mean 5 percen 95 percen Mode Mean 5 percen 95 percen ϕ Gamma α Uniform ρd Bea ρf Bea ρ d g Bea ρ f g Bea ρε Bea σd Invgamma* 1 Inf σf Invgamma* 1 Inf σ g d Invgamma* 1 Inf σ g f Invgamma* 1 Inf σε Invgamma* 1 Inf σ me y d Invgamma*.4 Inf N/A N/A N/A N/A σ me y f Invgamma*.4 Inf N/A N/A N/A N/A a : ME sands for Measuremen Error Noe: Invgamma indicaes ha 1 imes he parameers has a Inverse Gamma prior disribuion. 7

44 Table 3: Simulaed Model Performance Daa (Euroland) Simulaed Model(Euroland) Daa (US) Simulaed Model(US) ξ =.25 ξ = ξ =.25 ξ =. sd(dlyd,) sd(dlyf,) sd(dlcd,) sd(dlyd,) sd(dlcf,) sd(dlyf,) sd(dlid,) sd(dlyd,) sd(dlif,) sd(dlyf,) sd(dlhd,) sd(dlyd,) sd(dlhf,) sd(dlyf,) corr(dlcd,, dlyd,) corr(dlid,, dlyd,) corr(dlhd,, dlyd,) corr(dlcf,, dlyf,) corr(dlif,, dlyf,) corr(dlhf,, dlyf,) corr(dlyd,, dlyf,) corr(dlhd,, dlhf,) corr(dlcd,, dlcf,) corr(dlid,, dlif,)