Ademu Research outlined as presented at the Kick-Off Conference

1. A Model of the Twin Ds:
Optimal Default and Devaluation
by
S.Na S.Schmitt-Groh´e M.Uribe V.Yue
October 17, 2015
1

2. Motivation I
There is a strong empirical link between
sovereign default and large devaluations.
Reinhart (2002) examines data for 58 countries over the period
1970 to 1999 and finds that:
• The unconditional probability of a large devaluation in any 24-
month period is 17%.
• The probability of a large devaluation conditional on the 24-
month period containing a default is 84%.
• Reinhart refers to this phenomenon as the Twin Ds.
2

3. Motivation II
Excess Cumulative Devaluation Around 116 Default Episodes
−3 −2 −1 0 1 2 3
0
5
10
15
20
25
30
35
40
45
50
percent
Years after default
Excess devaluations
Default date
Devaluation around de-
fault is more akin to a
change in the level of
the nominal exchange rate
than to a switch to a
higher rate of deprecia-
tion.
Note. Median of cumulative devaluations conditional on default in year 0 minus unconditional
median. Sample contains 116 default episodes between 1975 and 2013 in 70 countries. Data
sources: Default dates, Uribe and Schmitt-Groh´e (2015). Exchange rates, WDI.
3

4. Argentina 1996-2006
1996 1998 2000 2002 2004 2006
0
1
2
3
4
Year
PesosperU.S.Dollar
Nominal Exchange Rate (E
t
)
1996 1998 2000 2002 2004 2006
6
12
Year
Nominal Wage (W
t
)
PesosperHour
1996 1998 2000 2002 2004 2006
0.4
0.6
0.8
1
1.2
1.4
Real Wage (Wt
/Et
)
Year
Index1996=1
1996 1998 2000 2002 2004 2006
20
25
30
35
40
Unemployment Rate + Underemployment Rate
Percent
Year
Vertical Line 1998, beginning of recession.
Vertical Line 2002, default and devaluation.
4

5. This Paper
– Develop a model that explains the Twin Ds phenomenon as
an optimal policy outcome.
• Main Elements
– Imperfect enforcement of debt contracts.
– Downward nominal wage rigidity.
• Intuition: Why is the Twin Ds Optimal?
– In the EG model, default occurs during large recessions.
– Depressed demand for labor puts downward pressure on real
wages, but downwardly rigid nominal wages cannot fall fast enough
to clear the market.
– A large devaluation reduces the real value of wages, thereby
avoiding massive unemployment.
5

6. Analytical Contributions
Decentralization of the Eaton-Gersovitz Model
Real models of sovereign default in the tradition of Eaton and
Gersovitz (1981) can be interpreted as the centralized version
of economies with default risk, decentralized borrowing, nominal
rigidity, optimal debt taxes, and optimal exchange-rate policy.
Why is this result important?
– Allows for the characterization of optimal exchange-rate policy
around default. In particular, one can answer the question of
whether the Twin Ds phenomenon can be understood as an
optimal outcome.
– Allows for the characterization of aggregate dynamics around
default when exchange-rate policy is suboptimal (e.g., currency
pegs).
6

7. Main Predictions of the Model
• The optimal policy calls for large devaluations of over 35%
around default events, ⇒ The Twin Ds emerges endogenously
as an optimal policy outcome.
• Under currency pegs, default episodes are accompanied by mas-
sive involuntary unemployment of around 20%.
7

8. The Model
8

9. Households
Choose cT
t , cN
t , dt+1 to
max E0
∞
t=0
βt
U(ct),
subject to
ct = A(cT
t , cN
t ),
PT
t cT
t + PN
t cN
t + Etdt = PT
t yT
t + Wtht + Et(1 − τd
t )qtdt+1,
ht ≤ ¯h,
where cT
t , cN
t (PT
t , PN
t ) consumption (price) of tradables,nontradables;
yT
t endowment of tradables; ht hours; Wtnominal wage; Et nom-
inal exchange rate; dt+1 debt chosen in t; qt price of debt; τd
t
debt tax.
• Households take ht as given.
• Debt is denominated in foreign currency (original sin).
9

10. Firms
Choose ht to
max PN
t F(ht) − Wtht ,
10

11. Downward Nominal Wage Rigidity
Wt ≥ γWt−1
γ = degree of downward wage rigidity.
γ = 0 ⇒ fully flexible wages.
Think of γ as being around 1. Schmitt-Groh´e and Uribe (2013)
estimate γ = 0.99 at quarterly frequency.
11

12. The Government
• Each period t, the government can be either in good financial
standing or in bad financial standing.
• If the government is in good financial standing, it can choose
to either honor its debt (indicated by It = 1) or default. If it de-
faults, it immediately acquires bad financial standing (indicated
by It = 0).
• If the government is in bad financial standing in t, then it
regains good financial standing in t+1 with exogenous probability
θ, and maintains bad standing with probability 1 − θ.
• If the country is in bad financial standing in t (It = 0), it cannot
borrow or lend in international credit markets: (1 − It)dt+1 = 0.
• When the government is in bad standing (It = 0), the country
suffers an output loss L(yT
t ) ⇒ endowment = yT
t − L(yT
t )(1 − It).
12

13. Risk-Neutral Foreign Lenders
The price of debt, qt, is given by
qt =
Prob{It+1 = 1|It = 1}
1 + r∗
.
where r∗ is the (constant) risk-free interest rate.
13

14. Quantitative Analysis
• Calibrate the model to an emerging economy (Argentina, 1983-
2001).
• Feed an estimated process for the endowment of tradables.
• Plot dynamics around a typical default under two exchange-rate
policies:
– The optimal float.
– A currency peg.
14

15. A Typical Default Episode Under Optimal Policy
−12 −8 −4 0 4 8 12
0.85
0.9
0.95
1
Tradable Output
yT
t − L(yT
t ) →
yT
t
−12 −8 −4 0 4 8 12
0.85
0.9
0.95
1
Consumption of Tradables, cT
t
−12 −8 −4 0 4 8 12
1
1.1
1.2
1.3
1.4
Nominal Exchange Rate, Et
−12 −8 −4 0 4 8 12
1.4
1.6
1.8
2
2.2
Real Wage, wt
−12 −8 −4 0 4 8 12
2
2.2
2.4
2.6
2.8
Relative Price of Nontradables, pt
−12 −8 −4 0 4 8 12
2
3
4
5
6
Country Interest-Rate Premium
%/yr
15

16. Observations On The Dynamics Around A Typical Default
Episode Under Optimal Policy
• Default takes place after a short but sharp contraction in trad-
able output.
• Default coincides with end of contraction and beginning of re-
covery.
• Contrary to what the intertemporal approach to the BOP would
suggest (but consistent with empirical evidence), the contraction
of consumption of tradables is more severe than that of output,
TB surplus. Reason: the interest rate premium doubles.
• In spite of the severe external crisis, the economy displays full
employment at all times.
• Full employment is achieved through large devaluations of over
35 percent (⇒ Twin Ds) that cause a large reduction in the real
wage and a significant real depreciation.
• Real depreciation mainly due to increase in nominal price of
tradables, as in actual data.
16

17. A Typical Default Episode With Fixed Exchange Rates
−12 −8 −4 0 4 8 12
0.85
0.9
0.95
1
Tradable Output, yT
t
−12 −8 −4 0 4 8 12
0.8
0.85
0.9
0.95
1
Consumption of Tradables, cT
t
−12 −8 −4 0 4 8 12
0
5
10
15
20
Unemployment Rate
%
−12 −8 −4 0 4 8 12
1.5
2
2.5
Real Wage, wt
−12 −8 −4 0 4 8 12
2
2.5
3
Relative Price of Nontradables, pt
−12 −8 −4 0 4 8 12
0
5
10
15
Country Interest-Rate Premium
%/yr
peg optimal devaluation
17

18. Observations On Typical Defaults With Fixed Exchange
Rates
• Default occurs after protracted contractions in tradable output.
• Defaults occur in the context of massive involuntary unemploy-
ment (over 20%) and highly depressed levels of consumption.
• The lack of nominal depreciation causes the real wage to stay
above the full employment real wage before, during, and after
default.
• Firms do not lower prices because costs (wages) remain high,
leading to much less real depreciation relative to optimal ex-
change rate policy.
18

19. Default, Devaluation, and Unemployment:
Argentina, Cyprus, Greece, and Iceland
1999 2000 2001 2002 2003 2004 2005
0.5
1
1.5
2
2.5
3
3.5
4
ExchangeRate,PesosperU.S.Dollar
Argentina
1999 2000 2001 2002 2003 2004 2005
6
8
10
12
14
16
18
20
UnemploymentRate,%
2009 2010 2011 2012 2013 2014 2015
0
1
2
ExchangeRate,Index
Greece
2009 2010 2011 2012 2013 2014 2015
10
20
30
UnemploymentRate,%
2004 2006 2008 2010 2012 2014
50
100
150
200
ExchangeRate,KronaperEuro
Iceland
2004 2006 2008 2010 2012 2014
2
4
6
8
UnemploymentRate,%
2011 2012 2013 2014 2015
0
0.5
1
1.5
2
ExchangeRate,Index
Cyprus
2011 2012 2013 2014 2015
5
10
15
20
UnemploymentRate,%
Unemployment Rate Nominal Exchange Rate
Note. Vertical line indicates the year of default. Own calculations based on data from INDEC
(Argentina), EuroStat, and the Central Bank of Iceland.
19

20. Conclusions
• A key prediction of the model is that under the optimal policy
defaults are accompanied by large devaluations. Hence the Twin
Ds phenomenon emerges as an optimal outcome.
• Under optimal policy, the central role of devaluations around
default episodes is to fend off unemployment.
• In fixed-exchange rate economies defaults are predicted to be
accompanied by massive unemployment.
• Fixed-exchange-rate economies are shown to support less debt
in the long run than optimal float economies.
• Paper shows that real economies with default risk `a la Eaton-
Gersovitz can be interpreted as the centralized version of economies
with default risk, downward nominal wage rigidity, optimal debt
taxes, and optimal devaluation policy.
20

21. Extras
21

22. Related Literature
• Fiscal consequence of devaluations, flow effects: Balance of
payment crisis literature. Devaluation rate as a way to create
seignorage to finance fiscal deficits (Krugman, 1979).
• Fiscal consequence of devaluations, stock effects: Devaluation
as indirect default on stock of local currency denominated debt
(Calvo, 1988; Corsetti and Dedola, 2014; Aguiar et al., 2013;
Da Rocha et al., 2013; Kriwoluzky et al., 2014; Moussa, 2013;
Du and Schreger, 2015).
• Real models of default `a la Eaton and Gersovitz. (Arellano,
2008; Aguiar and Gopinath, 2006; Hatchondo et al. 2010; Mar-
tinez and Sapriza, 2010; Chatterjee and Eyigungor, 2012; Men-
doza and Yue, 2012.)
22

23. Closing of the Labor Market
The following slackness condition is assumed to hold at all times:
(¯h − ht) Wt − γWt−1 = 0.
Express in real terms
(¯h − ht) wt − γ
wt−1
t
= 0,
where
t ≡
Et
Et−1
denotes the gross devaluation rate in period t
23

24. The Government (continued)
• If the country is in bad financial standing in t (It = 0), it cannot
borrow or lend in international credit markets:
(1 − It)dt+1 = 0
• The government rebates in a lump-sum fashion all revenues
from debt taxes τd
t qtdt+1.
• When the government defaults, it confiscates any payment
of households to foreign lenders, dt, and rebates them back to
households themselves.
• The budget constraint of the government is then given by
ft = τd
t qtdt+1 + (1 − It)dt
where ft is a lump-sum transfer to households.
24

25. Two Exogenous Costs of Default
(1) Financial Exclusion: While the country is in bad financial
standing (It = 0), it cannot participate in international credit
markets,
(1 − It)dt+1 = 0.
(2) Output Loss: The endowment received by households is
given by
˜yT
t =
yT
t if It = 1 (good standing)
yT
t − L(yT
t ) if It = 0 (bad standing)
where L(·) is a nondecreasing (loss) function and yT
t is an ex-
ogenous stochastic process.
25

26. Key Assumption of the EG Model: The decision to default
in any period t ≥ 0 depends on the minimum number of states
of the competitive equilibrium; Here: {yT
t , dt, wt−1}. Thus, the
probability of default in t+1 conditional on information available
in t depends in general on {yT
t , dt+1, wt}. It follows that in general,
the price of debt in t also depends on these three variables
qt = q(yT
t , dt+1, wt)
26

27. Competitive Equilibrium
cT
t = yT
t − (1 − It)L(yT
t ) + It[qtdt+1 − dt]
(1 − It)dt+1 = 0
λt = U (A(cT
t , F(ht)))A1(cT
t , F(ht))
It (1 − τd
t )qtλt − βEtλt+1 = 0
A2(cT
t , F(ht))
A1(cT
t , F(ht))
F (ht) = wt
wt ≥ γ
wt−1
t
; (ht − ¯h) wt − γ
wt−1
t
= 0; and ht ≤ ¯h
It qt −
EtIt+1
1+r∗ = 0
given policies {It, t, τd
t }.
27

28. Case 1: unrestricted τd
t & t
28

29. Competitive equilibrium with unrestricted τd
t & t
cT
t = yT
t − (1 − It)L(yT
t ) + It[qtdt+1 − dt]
(1 − It)dt+1 = 0
λt = U (A(cT
t , F(ht)))A1(cT
t , F(ht))
It (1 − τd
t )qtλt − βEtλt+1 = 0
A2(cT
t , F(ht))
A1(cT
t , F(ht))
F (ht) = wt
wt ≥ γ
wt−1
t
; (ht − ¯h) wt − γ
wt−1
t
= 0; and ht ≤ ¯h
It qt −
EtIt+1
1+r∗ = 0
given It. Policies { t, τd
t } picked to satisfy nonboxed conditions
29

30. Optimal Policy Problem: Pick {cT
t , ht, dt+1, It, qt} to max-
imize
E0
∞
t=0
βt
U(A(cT
t , F(ht)))
subject to cT
t = yT
t − (1 − It)L(yT
t ) + It[qtdt+1 − dt]
(1 − It)dt+1 = 0
It qt −
EtIt+1
1+r∗ = 0
ht ≤ ¯h
• States are: yT
t , dt; but wt−1 is not. • Clearly, solution features
full employment at all times, ht = ¯h. • After setting ht = ¯h, the
above problem is exactly Arellano (2008).
30

31. Summary of Analytical Results
Proposition (Decentralization Real to Real): Real models of
sovereign default in the tradition of Eaton and Gersovitz (1981)
can be decentralized via optimal debt taxes.
Proposition (Decentralization Real to Nominal): Real mod-
els of sovereign default in the tradition of Eaton and Gersovitz
(1981) can be interpreted as the centralized version of economies
with default risk, downward nominal wage rigidity, optimal debt
taxes, and optimal devaluation policy.
Proposition: The optimal policy induces full employment at all
times.
31

32. The Family of Optimal Devaluation Policies
t ≥ γ
wt−1
w
f
t
where w
f
t denotes the full-employment real wage, given by
w
f
t =
A2(cT
t , F(¯h))
A1(cT
t , F(¯h))
F (¯h)
Special case:
t =
wt−1
w
f
t
Properties: Full employment plus zero average inflation/devaluation.
32

33. Functional Forms and Calibration
U(c) =
c1−σ − 1
1 − σ
; σ = 2
A(cT
, cN
) = a(cT
)
1−1
ξ + (1 − a)(cN
)
1−1
ξ
1
1−1
ξ ; ξ = 1/2, a = 0.26
yN
t = hα
t ; α = 0.75
L(yT
t ) = max {0, δ1yT
t + δ2(yT
t )2
}
• Set β = 0.85, δ1 = −0.35, and δ2 = 0.44 to ensure:
(a) E(dt/yT
t ) = 60%,
(b) Prob of default equal to 2.6 per century, and
(c) Average output loss in autarky of 7%.
• Set γ = 0.99 ⇒ wages can fall by up to 4% per year.
• yT
t = 0.93yT
t−1 + 0.037µt, µ ∼ N(0, 1) (Argentina, 1983-2001)
33

34. The Output Cost of Default
yT
t
yT
t
yT
t − L(yT
t )
34

35. Empirical Evidence on the Behavior of Capital Controls and
Reserve Requirements Around Default
The model predicts that debt taxes increase as the economy
approaches default. Is this prediction of the model supported in
the data? Take a look at the next two plots. The first shows
that capital control measures increase and the second shows that
reserve requirements increase.
−3 −2 −1 0 1
0
1
2
3
4
%
Reserve Requirements
Years after default
−3 −2 −1 0 1
0.99
1
1.01
1.02
1.03
1.04
1.05
1.06
Years after default
Index
Capital Controls
Source. Own calculations based on data on capital controls from Fern´andez et al. (2015)
and on reserve requirements from Federico et al. (2014).
35

36. Case 2: unrestricted τd
t and t restricted
t = 1
This is a currency peg (recall that t ≡ Et/Et−1 denotes the
gross depreciation rate.
36

37. Optimal Default Under Currency Pegs
Suppose the central bank picks
t = 1 ∀t
• This case is of interest because of the recent experience in the
periphery of Europe where countries choose to stick to currency
pegs through severe external crises involving large increases in
country spreads and even sovereign defaults.
37

38. The Peg-Constrained Optimal Policy Problem:
Pick polices {It, τd
t } and all endogenous variables of the private-
sector equilibrium to maximize
E0
∞
t=0
βtU(A(cT
t , F(ht)))
subject to
cT
t = yT
t − (1 − It)L(yT
t ) + It[qtdt+1 − dt]
(1 − It)dt+1 = 0
A2(cT
t , F(ht))
A1(cT
t , F(ht))
F (ht) = wt; wt ≥ γwt−1; ht ≤ ¯h
It qt −
EtIt+1
1+r∗ = 0
38

39. Note: (1) Impossible to get rid of wage-rigidity constraints (ex-
cept for slackness); (2) States are now: yT
t , dt, wt−1

40. Long-Run Debt Sustainability under a Currency Peg
39

41. Density Function of External Debt
−1 −0.5 0 0.5 1 1.5
0
0.5
1
1.5
2
2.5
external debt (dt
)
density
Currency Peg
Optimal Devaluation Policy
Note. Debt distributions are conditional on being in good financial standing.
40

42. Observations on the figure
• In the long run, economies undergoing currency pegs can sus-
tain less debt than economies with optimal floats (20 vs. 60
percent of tradable output, respectively).
• Reason: Ex-ante, stronger incentive to default under a peg,
since default, by accelerating the recovery of consumption, helps
reduce unemployment. Under optimal devaluation, this channel
is not there, because the central bank guarantees full employ-
ment at all times, through appropriate movements in the nominal
exchange rate.
• However, ex-post, the peg economy does not predict a higher
default rate than the optimal float economy. The reason, is that
the lower level of debt reduces incentives to default.
41

43. Sensitivity Analysis
1. Long-Maturity Debt
2. Incomplete Exchange Rate Pass Through
3. Patience and the Twin Ds (higher β)
42

44. Optimal Devaluation Around the Typical Default Episode Under
Long-Maturity Debt
−12 −8 −4 0 4 8 12
1
1.05
1.1
1.15
1.2
1.25
Nominal Exchange Rate, Et
43

45. Optimal Devaluation Around the Typical Default Episode Under
Imperfect Pass-Through
−12 −8 −4 0 4 8 12
0.9
1
1.1
1.2
1.3
1.4
1.5
1.6
Nominal Exchange Rate, Et
Perfect Pass Through (η=1)
Imperfect Pass Through (η=0.5)
44

46. 3.) Predicted Twin Ds And Patience
−12 −8 −4 0 4 8 12
0.9
1
1.1
1.2
1.3
1.4
1.5
1.6
Nominal Exchange Rate, Et
β=0.85
β=0.95
β=0.98
45

47. The Twin Ds: Six Recent Examples
1998 2000 2002 2004 2006
1
1.5
2
2.5
3
Argentina
ExchangeRate
Year
2000 2002 2004 2006 2008
1
1.5
2
2.5
Uruguay
ExchangeRate
Year
1996 1998 2000 2002 2004
1
2
3
4
5
Ukraine
ExchangeRate
Year
1996 1998 2000 2002 2004
1
2
4
6
8
Russia
ExchangeRate
Year
2000 2002 2004 2006 2008
1
1.2
1.4
1.6
1.8
2
2.2
Paraguay
ExchangeRate
Year
1996 1998 2000 2002
0
1
2
4
6
8
10
ExchangeRate
Ecuador
Year
Nominal Exchange Rate Default Date
Note: Exchange rates are nominal dollar exchange rates, annual average, first observation
normalized to unity. Data sources: Default dates, Uribe and Schmitt-Groh´e (2015). Ex-
change rates, WDI.
46

48. Calibration
Parameter Value Description
γ 0.99 Degree of downward nominal wage rigidity
σ 2 Inverse of intertemporal elasticity of consumption
yT 1 Steady-state tradable output
¯h 1 Labor endowment
a 0.26 Share of tradables
ξ 0.5 Elasticity of substitution between tradables and nontradables
α 0.75 Labor share in nontraded sector
β 0.85 Quarterly subjective discount factor
r∗ 0.01 World interest rate (quarterly)
θ 0.0385 Probability of reentry
δ1 -0.35 parameter of output loss function
δ2 0.4403 parameter of output loss function
ρ 0.9317 serial correlation of ln yT
t
σµ 0.037 std. dev. of innovation µt
Discretization of State Space
ny 200 Number of output grid points (equally spaced in logs)
nd 200 Number of debt grid points (equally spaced)
nw 125 Number of wage grid points (equally spaced in logs)
[yT , yT ] [0.6523,1.5330] traded output range
[d, d]float [0,1.5] debt range under optimal float
[d, d]peg [-1,1.25] debt range under peg
[w, w]peg [1.25,4.25] wage range under peg
47

49. Predicted Debt And Default Probability
Across Exchange-Rate Regimes
Optimal
Float Currency
Policy Peg
Debt-to-traded-output ratio (qtr) 60% 20%
Number of Defaults per century 2.6 2.0
Country Premium 3.5% 2.5%
48

50. Data and Model Predictions Under the Optimal Float
E(r − r∗) σ(r − r∗) corr(r − r∗, y) corr(r − r∗, tb/y)
Data 7.4 2.9 -0.64 0.72
Model 3.5 3.2 -0.54 0.81
Note. Data moments are from Argentina over the inter-default period 1994:1 to 2001:3,
except for the default frequency, which is calculated over the period 1824 to 2013. In
the theoretical model, all moments are conditional on the country being in good financial
standing.
49

51. Business-Cycle Statistics:
Data and Model Predictions Under Optimal Exchange Rate Policy
σ(c)/σ(y) σ(tb/y)/σ(y) corr(c, y) corr(tb/y, y)
Data
Emerging Countries 1.23 0.69 0.72 -0.51
Argentina 1.11 0.48 0.75 -0.87
Model 1.22 0.57 0.88 -0.14
50

52. Do Countries Default in Bad Times?
Output Around Default Episodes
−3 −2 −1 0 1 2 3
−5
−4
−3
−2
−1
0
1
2
3
4
5
Percentdeviationfromtrend
Years after default
Source: Uribe and Schmitt-Groh´e, Open Economy Macroeconomics, 2014. Output is mea-
sured as real per capita GDP, log quadratically detrended at annual frequency. Median across
105 default episodes over the period 1975-2014.
51

53. Consumption, Investment, The Trade Balance, and The
Real Exchange Rate Around Default Episodes
−3 −2 −1 0 1 2 3
−6
−4
−2
0
2
4
Percentdeviationfromtrend
Years after default
Real Exchange Rate
−3 −2 −1 0 1 2 3
−1
−0.5
0
0.5
1
1.5
Percentdeviationfromtrend
Years after default
Trade−Balance−To−Output Ratio
−3 −2 −1 0 1 2 3
−20
−10
0
10
20
Percentdeviationfromtrend
Years after default
Investment
−3 −2 −1 0 1 2 3
−4
−2
0
2
4
6
Percentdeviationfromtrend
Years after default
Consumption
Source: Uribe and Schmitt-Groh´e, Open
Economy Macroeconomics, 2014. Con-
sumption, investment, and the real ex-
change rate are log-quadratically de-
trended. The trade-balance-to-output
ratio is linearly detrended. An increase
in the real exchange rate indicates a real
appreciation of the domestic currency.
52

54. Is there wage restraint during booms?
Example: Periphery of Europe during the 2000-2008 Boom
53

55. Boom-Bust Cycle in Peripherical Europe: 2000-2011
2002 2004 2006 2008 2010
6
7
8
9
10
11
12
13
14
Percent
Date
Unemployment Rate
2002 2004 2006 2008 2010
50
60
70
80
90
100
110
Index,2008=100
Date
Labor Cost Index, Nominal
2002 2004 2006 2008 2010
−14
−12
−10
−8
−6
−4
−2
Percent
Date
Current Account / GDP
Data Source: Eurostat. Data represents arithmetic mean of Bulgaria, Cyprus,
Estonia, Greece, Ireland, Lithuania, Latvia, Portugal, Spain, Slovenia, and Slovakia
⇒ Wages grew by 70 percent between 2000 and 2008!
54

56. A Closer Look At Spain And Ireland
55

57. Nominal hourly wages in Spain increase by 44 percent dur-
ing the 2000-2008 boom
2000 2002 2004 2006 2008 2010 2012
60
70
80
90
100
110
Index,2008=100 Nominal Hourly Wages: Spain
56

58. Nominal hourly wages in Ireland increase by 57 percent
during the 2000-2008 boom
2000 2002 2004 2006 2008 2010 2012
60
70
80
90
100
110
Index,2008=100 Nominal Hourly Wages: Ireland
57

59. ... Despite No Growth in Total Factor
Productivity
1996 1998 2000 2002 2004 2006
90
95
100
105
110
115TFP,Index1995=100
Spain
Ireland
58

60. Total Factor Productivity: 2000-2007
(value added based), Index (1995=100)
2000 2001 2002 2003 2004 2005 2006 2007
Spain 96.2 95.6 94.8 94.1 93.4 92.4 91.9 92.1
Ireland 109.0 111.2 112.6 110.5 110.9 108.6 106.4 107.8
Source: EU KLEMS Growth and Productivity Accounts. This database in-
cludes measures of output and input growth, and derived variables such as
multifactor productivity at the industry level. The input measures include
various categories of capital (K), labour (L), energy (E), material (M) and
service inputs (S). The measures are developed for 25 individual EU member
states, the US and Japan and cover the period from 1970 to 2007. The
variables are organised around the growth accounting methodology, a major
advantage of which is that it is rooted in neo-classical production theory. It
provides a clear conceptual framework within which the interaction between
variables can be analysed in an internally consistent way. The data series are
publicly available on http://www.euklems.net. November 2009 release.
59

61. Evidence On Downward Nominal Wage Rigidity
• Downward nominal wage rigidity is the central friction in the
present model ⇒ natural to ask if it is empirically relevant.
• Downward wage rigidity is a widespread phenomenon:
— Evident in micro and macro data.
— Rich, emerging, and poor countries.
— Developed and underdeveloped regions of the world.
• Byproduct: Will obtain an estimate of the parameter γ govern-
ing wage stickiness in the model (useful for quantitative analysis).
60

62. Downward Nominal Wage Rigidity:
Evidence From Micro Data
61

63. Probability of Decline, Increase, or No Change in Wages
U.S. data, SIPP panel 1986-1993, between interviews one year apart.
Interviews One Year apart
Males Females
Decline 5.1% 4.3%
Constant 53.7% 49.2%
Increase 41.2% 46.5%
Source: Gottschalk (2005)
• Large mass at ‘Constant’ suggests nominal wage rigidity.
• Small mass at ’Decline’ suggests downward nominal wage rigid-
ity.
62