BANK OF FINLAND DISCUSSION PAPERS

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1 BANK OF FINLAND DISCUSSION PAPERS 0/99 David G. Mayes Jouko Vilmunen Research Deparmen Unemploymen in a Small Open Economy: Finland and New Zealand SUOMEN PANKIN KESKUSTELUALOITTEITA FINLANDS BANKS DISKUSSIONSUNDERLAG

2 Suomen Pankki Bank of Finland P.O.Box 60, FIN-000 HELSINKI, Finland

3 BANK OF FINLAND DISCUSSION PAPERS 0/99 David G. Mayes Jouko Vilmunen Research Deparmen Unemploymen in a Small Open Economy: Finland and New Zealand The views expressed are hose of he auhors and do no necessarily correspond o he views of he Bank of Finland.

4 ISBN ISSN Suomen Pankin monisuskeskus Helsinki 999

5 Unemploymen in a Small Open Economy: Finland and New Zealand Bank of Finland Discussion Papers 0/99 David G. Mayes Jouko Vilmunen Research Deparmen Absrac Unemploymen is now he key issue for economic policy in he OECD and Europe in paricular. By examining daa from he period for wo highly differen small open OECD economies, Finland and New Zealand, in a VEC model his paper seeks o cas ligh on hree quesions: he degree o which unemploymen has been he resul of slow adjusmen o large exernal shocks; he degree o which differences in labour marke srucures can lead o differen responses o shocks; he imporance of he exchange rae and he exernal secor in resolving he problem. The approach uses a fairly general model of he labour marke ha includes wages, unemploymen, he capial sock and he erms of rade. I uses coinegraion analysis o esablish long-run relaionships among he four variables. In he case of Finland we find ha he shor-run response of unemploymen o shocks (o he long-run relaionship) is large relaive o he response of real wage and he erms of rade. In New Zealand on he oher hand boh real wages and he erms of rade, in paricular, adjus more rapidly. As a resul he burden of shor-run adjusmen in he New Zealand economy appears o fall more heavily on (relaive) prices. Since he unemploymen rae in boh counries displays hyseresis, hese resuls sugges ha relaive price adjusmen in he New Zealand economy is more effecive in prevening adverse aggregae shocks from becoming adverse unemploymen shock. Keywords: unemploymen, open economy, srucural change, labour marke 3

6 Työömyys pienessä avoaloudessa: Suomi ja Uusi-Seelani Suomen Pankin keskuselualoieia 0/99 David G. Mayes Jouko Vilmunen Tukimusosaso Tiiviselmä Tukimuksessa arkasellaan kahden pienen avoalouden, Suomen ja Uuden-Seelannin, yöömyyeen vaikuavia ekijöiä viimeisen yli 30 vuoden aikana. Tukimuksella pyriään hakemaan lisävalaisusa kolmeen kysymykseen: missä määrin yöömyyden kasvu johuu hiaasa sopeuumisesa aloueen kohdisuviin suuriin häiriöihin, missä määrin yömarkkinoiden rakeneellise ero synnyävä erilaisuua yömarkkinoiden vaseessa häiriöihin ja lopuksi, mikä on valuuakurssin ja avoimen sekorin merkiys yöömyysongelman rakaisussa. Tukimuksen eoreeise arkaselu perusuva suheellisen avanomaiseen palka, yöömyyden, pääomakannan ja vaihosuheen käsiävään avoalouden yömarkkinamalliin. Yheisinegroiuvuusanalyysin avulla pyriään saamaan selville, löyyykö maiden havainoaineisoisa ukea mallin muuujien pikän aikavälin riippuvuuksille. Tulosen peruseella Suomen kokonaisaloudellinen sopeuuminen poikkeaa Uuden- Seelannin alouden käyäyymisesä sikäli, eä Suomessa yöömyys reagoi lyhyellä aikavälillä suheellisen voimakkaasi häiriöihin, joka kohdisuva yöömyyden, reaalipalkan, vaihosuheen ja pääomakannan väliseen pikän aikavälin riippuvuueen. Tasapainoomuude ilmenevä sien Suomessa vahvasi juuri yöömyydessä. Uudessa-Seelannissa vaihosuheen ja vähäisemmässä määrin reaalipalkan muuokse ova vasaavassa asemassa. Kummankin maan yöömyydessä ilmenee kuienkin hysereesia eli voimakasa jälkivaikuusa; jos yöömyys yllääväsi muuuu, ova nämä muuokse suheellisen pysyviä. Tulokse näyäväkin näin ollen viiaavan siihen, eä suheellisen hinojen kuen reaalipalkkojen ja vaihosuheen muuokse vaimenava ehokkaammin kokonaisaloudellisen häiriöiden kieleisiä yöömyysvaikuuksia Uudessa-Seelannissa. Asiasana: hidas sopeuuminen, avoalous, yheisinegroiuvuus, virheenkorjaus 4

7 Conens Absrac... 3 Inroducion The problem o be addressed Our approach The model and is conex A macroeconomic model of he labour marke in a small open economy... 3 Empirical analysis of he Finnish and New Zealand daa Economeric preliminaries: coinegraion analysis Esimaion resuls for Finland Uni roo esing on he Finnish daa Coinegraion analysis of he Finnish daa Esimaion resuls for New Zealand Uni roo esing Coinegraion analysis Summary and discussion References Appendices

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9 Inroducion. The problem o be addressed While price sabiliy is sill a key focus of economic policy, unemploymen has aken over in OECD as he major problem urgenly seeking a soluion. This paper seeks o make a conribuion o he undersanding of he causes of unemploymen and is successful reducion. I explores he example of wo raher differen small open economies, Finland and New Zealand, as heir conrass shed ligh on hree key issues: he degree o which unemploymen has been he resul of slow adjusmen o large exernal shocks he degree o which differences in labour marke srucures can lead o differen responses o shocks he imporance of he exchange rae and he exernal secor in resolving he problem The policy prescripions for rying o handle unemploymen are very differen if he problem is largely ha adjusmen o shocks akes an unaccepably long ime raher han if i is ha srucural change in he economy means ha unemploymen will coninue a a higher level. In he firs case he effor needs o go ino improving he operaion of he labour marke iself, while in he second i is he srucure affecing he demand and supply of labour ha needs o change. The wo counries have experienced sep and rend increases in unemploymen. Boh New Zealand and Finland have been subjec o major shocks, which if no permanen are cerainly enduring he resricion of radiional agriculural markes in he case of New Zealand and he collapse of he former Sovie Union in he case of Finland. They have also become aware of increasing difficulies (non-susainable rends) wih underlying aspecs of heir insiuional srucures. Finland, o a lesser exen han Sweden, has found ha here are limis o he Nordic model of he exensive social benefi sysem and increasingly imporan role of he public secor. New Zealand found ha he process of increasing regulaion and insulaion from consequences of exernal disorions was no susainable. The hisorical profiles of unemploymen are fairly similar. Boh New Zealand and Finland have seen unemploymen rise markedly (from 4 % in he mid 980s o % in 992 in New Zealand and from 5 % in he mid-980s o 8 % in Finland by he end of 993) and seen i fall away fairly rapidly since (o 6 % in New Zealand in 995 and o 3 % in Finland in 996). In boh counries even he saring values for unemploymen in he mid-980s were hough o be unaccepably high compared wih pos-war hisory and urgen acion was hough o be needed. The desired process of reducion in unemploymen is by no means over. Nor are he responses o he shocks fully played ou ye. Our evidence is hus parial bu so i is in all he res of he OECD counries where unemploymen rose on his sor of scale. There are, however, imporan differences beween he wo counries ha make hem a good illusraion of he range of possible responses. In New Zealand he response has been wide-reaching, involving he rapid reducion of exernal 7

10 barriers o rade, he liberalisaion of he domesic economy and he inroducion of subsanial change ino he operaion of he labour marke iself. The response in Finland has been much more mued, alhough smaller moves in all hree direcions have occurred paricularly wih membership of he EU. As our analysis shows he behaviour of he wo labour markes has also been differen. The role of unemploymen, in paricular, in he adjusmen o aggregae shocks appears o be differen in wo economies; whereas unemploymen in boh economies displays exreme persisence in he sense of a uni roo in he generaing process hyseresis he burden of adjusmen o aggregae shocks is more biased owards unemploymen in Finland. As in so many insances i is difficul o isolae hese various effecs. The naure of hese adjusmen processes o shocks has been heavily obscured by he business cycle, as he period of observaion is shor. Boh counries have seen a major economic cycle and a period of fiscal reform, which has exacerbaed unemploymen in he shor run bu conribued o is reducion in he longer erm. However, while New Zealand has reurned o a budge surplus, a susainable long run fiscal posiion and has deb o GDP raio of 30 % and falling, Finland is inside he Maasrich crieria of a 3 % defici o GDP raio and a 60% deb o GDP raio bu has longer-run problems sill o resolve. Neverheless, one feaure sands ou in boh of he adjusmen processes, namely he role of he real exchange rae in having a rapid favourable impac on compeiiveness (wihou much inflaion) in he urnround and up phases of he cycle and a major impac on bringing down inflaion (wihou a decline in aciviy in New Zealand in he opposie phase, unil he impac of he Asian crisis came hrough). The UK and Sweden have had similar experiences following heir 992 devaluaions. Finland will ener Sage 3 of EMU in he firs wave in 999 and he apparen sabiliy of he nominal exchange rae wih respec o he oher euro counries already anicipaed Finland s enry prior o he acual decision in he beginning of May 998. Hence while New Zealand s nominal exchange rae has already moved downwards subsanially as he economy moves owards he recovery phase of he cycle when, i is hoped, unemploymen will be able o resume is downward momenum, Finland will no longer have his mechanism in euro markes..2 Our approach We can only hope o shed ligh on a process which is incomplee and we do so largely by disenangling key feaures of he daa relaing o unemploymen in he wo counries and is evoluion over ime. In he nex secion we develop a very simple model of he characerisics of he labour marke ha builds on he exising lieraure. This model enables us o disinguish progressive influences and permanen and emporary shocks o he labour marke bu is principal focus is on he dynamics of he ineracions of he labour marke so ha we can esablish he exen of he persisence of unemploymen in response o hose shocks. Secion 3 hen explains he saisical approach based on coinegraion analysis, which is used o esimae he model and explores he oucomes for Finland and New Zealand in urn. The hreads of he wo examples are drawn ogeher in Secion 4, which ses ou our conclusions for he hree key issues of persisence, differences in srucure and he role of exernal compeiiveness. 8

11 2 The model and is conex Unemploymen has, over he years, gained in imporance among he se of socioeconomic problems faced in he OECD, paricularly in Europe, and is currenly high on agenda of he candidae counries for he hird sage of Economic and Moneary Union. In one sense, unemploymen has become a problem in he region as a whole only since he mid-970s or early 980s. Alhough he unemploymen rae also increased in Europe prior o 975, he increase was relaively modes (from around 3 % in 960 o less han 4 % in ). However in boh Finland and New Zealand i was considerably lower han he average before he mid 970s, so figures as low as 3 % were regarded as being unaccepably high. Wih he wo oil-price shocks in he 970's he picure has changed. The second crisis, in paricular, marked a difference beween he behaviour of he European and oher OECD economies. Whereas he OECD average unemploymen rae peaked a approximaely 8 % in , i coninued o rise in Europe and exceeded 0 % in before saring o fall. In he 990's unemploymen rae has once again risen in he OECD area in general and in Europe in paricular, where i was around 0.5 % in mid-998 compared wih he OECD average of 7.2 %. Hence, he unemploymen gap beween OECD- Europe and he res of he OECD has no come down since i emerged in , bu has acually risen in recen years. The ime series paern of he European unemploymen rae hen clearly suggess ha here is somehing like he European Unemploymen Problem noion used by Ljunqvis and Sargen (998) o head heir recen conribuion. New Zealand has followed a middle course, neiher showing he sabiliy of employmen a lower levels in he US and Japan nor he more persisen higher levels of Europe. Various heories have been proposed o explain he rise in European unemploymen. Blanchard and Summers (986) and Lindbeck and Snower (988) impue he oucome o insider-ousider conflics beween employed and unemployed workers ha arose in he highly unionized economies in Europe. Benolila and Berola (990) sudy he idea ha excessive European hiring and firing coss conribued o higher unemploymen. Blanchard (998) emphasizes capial accumulaion and facor prices when he revisis he European unemploymen problem. There has been wage moderaion in Europe since he mid-980s bu i has no led o a decrease in unemploymen, because here has been an adverse shif in labour demand by firms. Blanchard argues ha eiher a shif in he disribuion of rens away from workers or a echnological bias agains labour explains his shif. Malinvaud (994) focuses on he effecs of capial shorage, which, according o his argumen, was caused in Europe by high real wages in he 970's and high real ineres raes in 980's. This hypohesis of a capial shorage can, quie naurally, also be he oucome of various oher facors. The underlying idea is simply ha some exogenous facor(s) reduce he profiabiliy of producion, e.g. by inducing a persisen fall in (anicipaed fuure) oupu prices, which, in urn, end o reduce incenives o inves and he need for capial. I is prima facie likely ha New Zealand and Finland will have quie a lo in common in his regard up ill he second half of he 980s. 9

12 An ineresing feaure of mos of hese explanaions is, as noed by Ljunqvis and Sargen (ibid. p. 6), ha hey assign he problem o he demand for labour, making he decisions eiher of employers or of unionized employed workers susain a high unemploymen rae. Ljunqvis and Sargen (ibid.), on he oher hand, focus on he effecs of he welfare sae on he supply of labour and hope o conribue a sense of how he welfare sae adversely affecs he dynamic responses o economic shocks and o increasing urbulence in he economic environmen. The saring poin of heir analysis is he well-known claim ha high-income axaion and generous welfare benefis disor workers labour supply decisions. 2 This facor forms an imporan difference beween Finland and New Zealand. Unforunaely, here is no general agreemen among economiss regarding he bes approach o modelling unemploymen in Europe. Saying his we do no wan o convey he impression ha here has been no heoreical progress in he aemps o idenify he deerminans of (he naural rae of) unemploymen 3 nor ha he various heories proposed in he lieraure are no broadly consisen he European unemploymen numbers. Raher, as also argued by Nickell (998), here seems o be a lack of a saisfacory empirical explanaion of he ime series paern of unemploymen in Europe, or OECD for ha maer. 4 The growh oriened approaches o unemploymen build on he Schumpeerian (942) noion of creaive desrucion and emphasize how growh and echnological progress exer a coninuous pressure on he economy o reallocae is resources from conracing secors o expanding ones. This on going process of reallocaion of he economy s facors of producion is ofen called churning (Caballero and Hammour, 998c). The ransacion beween capial and labour when hese are combined o form new producion unis suffers from an appropriabiliy problem, whenever invesmens exhibi some degree of specificiy w.r.. labour (Caballero and Hammour, 986, 998b), which in urn gives rise o quasi rens and insider power o workers. Unemploymen in his conex acs as an equilibrium response o he economic sysem ha resrains he bargaining posiion of he insiders and preserves he profiabiliy of invesmens (Caballero and Hammour, 986, p. 88; on he macroeconomic effecs of specificiy, see Caballero and Hammour, 998a). 2 The asserion of Layard, Nickell and Jackman (99, p. 62) ha uncondiional paymen of benefis for an indefinie period is clearly a major cause of high European unemploymen should also be menioned, as i is born ou by he analysis of Ljunqvis and Sargen. Ljunqvis and Sargen (998) formulae a general equilibrium search model where workers skills depreciae during unemploymen spells, and unemploymen benefis are deermined by workers pas earnings. Simulaions of he model clearly bring ou he sensiiviy of he equilibrium unemploymen rae o he amoun of skills los by lay-offs. Their analysis aribues he persisenly higher unemploymen from 980 s o he increased urbulence, as measured by a special urbulence parameer, in he economic environmen, while also explaining how lower unemploymen raes in he 950 s, he 960's and he early 970 s were susainable under more ranquil economic condiions. 3 Indeed, Blanchard and Kaz (996) even go as far as o argue ha he heoreical progress over he las 30 years or so has acually produced a framework for he analysis of he deerminans of he naural rae. 4 Ljunqvis and Sargen (ibid. p. 6) also poin o he possibiliy ha one reason for he pas lack of emphasis on workers disored incenives as an explanaion for high European unemploymen mus be he scarce empirical suppor for he idea. They argue ha many empirical sudies have failed o find any cross-counry correlaion beween unemploymen benefis and aggregae unemploymen, and his has given rise o he conclusion ha generous enilemen programs are no o be blamed for high unemploymen raes. I appears, however, ha unemploymen raes do respond o benefi enilemens, bu only wih a considerable lag of 5 o 0 years, and in some cases 0 o 20 years. Why are he lags so long hen? Ljunqvis and Sargen argue ha lags are purely coincidenal, and he real explanaion for persisenly higher European unemploymen from he 980 s is o be found in a changed economic environmen. 0

13 Quie recenly, fresh ideas on modelling he deerminans of he ineracion beween (lagged) labour marke dynamics and (ime-varying) naural rae, in paricular, have suggesed approaches ha have high empirical conen. One of he mos ineresing ones of hese, proposed by Karanassou and Snower (997b), 5 explores he implicaions of he ineracion of persisen effecs of emporary shocks (or of unemploymen persisence) and delayed effecs of permanen shocks (or of imperfec unemploymen responsiveness) on long-erm unemploymen and analyzes hese effecs by deriving he long-erm implicaions of he chain reacion heory of unemploymen. The idea is simply ha inherenly lagged dynamics in he labour marke inerac wih growing exogenous variables (populaion growh, capial sock ec.) o produce long-erm effecs from labour marke lags, in addiion o he ypical shor-erm effecs. Our objecives in his paper are more modes han in he recen lieraure on long-erm unemploymen, as exemplified e.g. by Karanassou and Snower (ibid.). We aemp o model long-erm unemploymen deerminaion wih a vecor ime series of relaively low-dimension consising of unemploymen and a number of poenially imporan facors correlaed wih unemploymen as a (possibly) coinegraed sysem. Coinegraing vecor(s) hen give us esimaes of he longerm (saic) relaionship beween he sysem variables. In paricular, we es for he exogeneiy of he oher variables w.r.. he parameers of he coinegraion relaionship. This is he firs sep in rying o idenify an unemploymen equaion from he sysem. Granger's represenaion heorem (Granger and Engle, 99) implies ha a coinegraed sysem can equivalenly be represened in an Error Correcion Form, which summarizes he shor-run dynamics of he changes of he sysem. I is well known ha coinegraion implies causaliy among he variables in he sysem. Tesing for non-causaliy of unemploymen w.r.. o oher variables in he sysem can finally be used o check wheher single-equaion approach o modelling unemploymen is fully efficien. 2. A macroeconomic model of he labour marke in a small open economy The analyical framework, which underpins he srucure of he esimaed coinegraion vecors in secion 3, follows he mainsream of he macro-oriened labour economics in consising of a labour and supply funcion as well as a wage seing equaion. We ake he Jacobson e al. (996) model and modify i o reflec he openness of he economy. Producion possibiliies are described by he (log of he) Cobb-Douglas funcional form y = βk + αl + µ () where y, k and l denoe, respecively, oupu, capial and labour, and µ is a sochasic shock o echnology or producion possibiliies (i.e. a produciviy shock), whose generaing process may conain a uni roo. Employmen is assumed o be given by 5 See also Karanassou and Snower (997a, 998).

14 l = γ + γ k γ ν + ζ (2) 0 2 where ν = ln(w/p) is he real produc wage, W he nominal wage, P he oupu price and ζ an employmen shock. If he firm is maximizing profis, hen γ = βγ 2 and γ 2 = /( α) and ζ l = γ 2 µ. Capial is deermined by k = ρ + ρ l ρ r + ζ (3) 0 2 where r is he (log of he) renal price of capial, R, or, simply, he real ineres rae. In wha follows we assume ha he real ineres rae is consan 6 and hence subsumed by he consan ρ 0. Noe ha employmen and capial sock share he same shock ζ, which essenially derives from he underlying shocks o echnology, µ. For his reason ζ will be simply refered o as a echnological shock. Under profi maximizaion ρ = α/( β). Labour supply is given by s l = θ w + ξ (4) where w = ln(w/π) is he consumpion real wage and Π is he consumer price index wih he share of domesic consumer goods in he index denoed by φ. 7 Non-modelled facors affecing labour supply decisions by households 8 are represened by he sochasic shif variable ξ, which is generaed by a process ha poenially conains a uni roo. Furhermore, we assume ha he wage seing relaion is w = σ u + σ2 q + ωw, (5) 6 The real ineres rae has in fac varied over he period and has affeced oher variables in he model, paricularly unemploymen, as also emphasized by Phelps and Zoega (998) iner alia. However, we could no disenangle hose effecs from he daa. In any case reliable ineres rae daa may be hard o come by, since a large par of he sample comes from a period of financial (rae) regulaion in he wo counries. 7 Such a labour supply funcion can be derived from an underlying (saic) consrained uiliy maximizaion problem, where he uiliy funcion is separable in leisure, H, and aggregae consumpion, C, and quasi-linear in form, i.e. u(c, H) = C κ( H) ρ and where he budge consrain can be wrien as C + wh = w (ime endowmen normalized o ), where w denoes he real consumpion wage, W/Π. Aggregae consumpion, on he oher hand, corresponds o he Cobb-Douglas uiliy aggregaor in he consrained uiliy maximizing decision on he allocaion of consumpion across domesic and foreign goods, so ha Π can be hough of as he cos minimizing price of a uni of aggregae consumpion and can be wrien as P φ (P*S) φ, where P* and S denoe he foreign price level and nominal exchange rae, respecively. 8 These non-modelled facors could conceivably include preference shocks (beween consumpion and leisure), changes in he labour flow across borders (ne immigraion), changes in he birh and moraliy raes, reservaion wages and social safey nes (unemploymen and oher benefis) ec. 2

15 where u and q denoe, respecively, he log of unemploymen U and he erms of rade Q. 9 This paricular form of he wage seing equaion differs slighly from he sandard one in he lieraure (e.g. Jacobson e al. eq. (4) p. 4). Typically, he real produc wage is expressed in erms of unemploymen and produciviy, he former affecing real wages negaively and he laer posiively. Above, real consumpion wage depends on he erms of rade movemens and negaively on unemploymen. This paricular form of he wage seing relaion basically resuls from he fac he difference beween real produc and real consumpion wage in an open economy is relaed o he erms of rade. For a Cobb-Douglas ype consumer price index (see fn. 7), we have ν w = ( φ)q. Since labour supply decisions depend on he consumpion real wage and labour demand decisions on he real produc wage, changes in he erms of rade will affec he sae of he labour marke. 0 In any case, equaion (5) is paricularly useful in he sense ha i emphasizes he erms of rade as a poenial source of aggregae flucuaions affecing he economy. Hisorically Finland, for example, has been subjec o raher large erms of rade swings, paricularly a he business cycle frequencies, which also conribues o explaining why he erms of rade is included in he daa se for he empirical analysis. As for he non-modelled facors affecing wage formaion, i.e. shocks o wage formaion, ω w,, i is assumed ha i oo is generaed by a process ha poenially conains a uni roo. 2 Hence, he wage, employmen and labour supply shock and he shock o he capial sock can, wihou loss of generaliy w.r.. o he long-run properies of he model, be represened simply as an AR() process of he form V = ψ V + ε V, (6) where 0 < ψ, (i.e. (6) can be a pure random walk). 3 The main reason for waning flexibiliy in he sochasic srucure of he shocks is ha he coinegraion implicaions of he model depend on he number of uni roos in he exogenous sochasic processes. For example, if shocks o 9 Terms of rade usually refers o he price of domesic expors relaive o impors in domesic currency. Hence, i is he relaive price associaed wih radable goods. The real exchange rae, on he oher hand, is ofen defined as he raio of domesic and foreign price levels (in domesic currency). In he heoreical conex of a single good small open economy, hese wo coincide. This is he main reason for us o use erms of rade in a loose sense in heoreical conex of he main ex. 0 The lieraure on wage indexaion (Gray, 976; Fischer, 977; Karni, 983), especially in open economies (Turnovsky, 983; Aizenmann and Frenkel, 985a, b) under opimal wage indexing (Devereux, 988; Vilmunen, 992) provides a very useful heoreical background in his conex. Blanchard and Kaz (996) argue ha research developmen has resuled in a racable framework for he (macroeconomic) analysis of unemploymen problems, and ha he se of exogenous deerminans affecing long-run unemploymen has o be adjused o reflec he conex of applicaion. The idea here is similar in spiri; he emphasis here is no only on he naure of shocks as such, bu also on he propagaion mechanism underlying unemploymen deerminaion in small open economies. 2 These non-modelled facors could include (insiuional ec.) parameers relaed o wage bargaining as well as various resricions, such as minimum wage laws, on wage formaion. Also, shock o real ineres raes could affec he sochasic behaviour of shocks o wage formaion. 3 We could generalize equaion (6) by leing ψ and reaining he propery ha J V, is saionary. In his more general case, V is saionary, bu no necessarily an AR() process, when ψ <. On he oher hand, when ψ =, V is inegraed of order, I(), bu no necessarily a pure random walk. 3

16 wage formaion are generaed by a random walk and u I() and q I(), hen he rivariae sysem X = (w, u, q ) canno be coinegraed (i.e. linear combinaions β X in he presen conex canno be I(0)), whereas saionary, mean revering shocks o wage formaion imply coinegraion among hese variables. This implicaion of he wage shock is emphasised also by Jacobson e al. (996 p. 6). Finally, flucuaions in he erms of rade evolve according o q = δ k δ2 l + ωq, (7) where δ i > 0. (7) can be derived by combining an IS-schedule linking compeiiveness o aggregae demand (a he consan real ineres rae) 4 wih an aggregae supply behaviour implied by () (3), i.e. he erms of rade balances aggregae demand and supply. Under his inerpreaion, he erms of rade shocks ω q is a combinaion of aggregae demand and supply shocks (or shocks o he producion echnology). Thus i is possible ha ω q is generaed by a process conaining a uni roo, so ha ω q can be represened as ω q, = ψ q ω q, + J q,, 0 < ψ q. An alernaive inerpreaion relies on mark-up pricing under exogenous erms of rade shocks. From equaions (2) and (4) we can obain an expression for (he rae of) unemploymen 5 (he consan has been ignored) u s = l l = ( θ + γ ) w γ 2 ( φ) q γ 2 k + ξ ζ. (8) The demand for capial funcion (3), on he oher hand, can be wrien in an alernaive form as (once again ignoring he consan) k = ρ s = ρ u [l l ] + ρ + ρ θ w s l + ζ + ζ + ρ ξ (9) which may prove useful when inerpreing possible coinegraion relaionship; in paricular, he sochasic properies of he linear combinaion k + ρ u ρ θw will depend on he sochasic properies of he linear combinaion, ζ +ρ ξ, of shocks o labour demand and supply. 4 I.e. he underlying IS-schedule is y = aq + u for some posiive a, where u denoes exogenous IS or aggregae demand shocks, and includes fiscal policy shocks, exogenous shocks o consumpion and invesmen ec. Implicily we are absracing from ineres rae deerminaion and simply ake he real ineres rae is as paramerically given. 5 Noe ha according o (9), long-run unemploymen need no be independen of shocks o labour demand and supply. Lindbeck (993) argues ha a realisic macroeconomic heory should have long-run unemploymen independen of produciviy and labour supply shocks. This is very similar in spiri o he idenificaion scheme used by Blanchard and Quah (987) o idenify aggregae demand and supply shocks, and is similar o wha Blanchard and Kaz (996, p. 9) argue. Above, independence will prevail essenially if ξ ζ is saionary, which, in he case of uni roos in labour demand and supply shocks, boils down o ξ and ζ sharing a common rend. Produciviy, or a similar paricular form of echnological progress, would probably be he mos plausible inerpreaion of his common rend, since shocks o produciviy would affec no only labour demand, bu also labour supply (see e.g. Blanchard and Kaz, 996, pp. 9 0). 4

17 Now, we can use he preceding model o moivae our coinegraion analysis in he nex secion. Wihou solving he model explicily (see Jacobson e al. 996), we know ha he vecor of he four endogenous variables of ineres, X = (u, w, q, k) can be solved 6 as a linear funcion of he underlying vecor of shocks F = (ζ, ω w, ξ, ω q ) = (V, ω q ), i.e. X = A F (0) where A is (4 x 4)-marix summarizing he impac effecs of he shocks. 7 Equaion (0) is a paricularly useful represenaion of he soluion, since i enables us o conrol for he number of coinegraing relaions more explicily (as he mirror image of he number of sochasic rends, i.e. independen uni roo processes). Clearly, he sysem in (0) consising of he four endogenous variables may be driven by up o four independen uni roo processes, in which case here exiss no coinegraing relaions among he variables (u, w, q, k) (Sock and Wason, 99). If, on he oher hand, one of he processes in F is saionary, hen here is one coinegraing relaion among he variables (u, w, q, k), i.e. here are hree sochasic rends. A he oher exreme, if only one of he exogenous driving processes, i.e. shocks o he labour supply, is a uni roo process, hen here are hree coinegraing relaions among he variables (u, w, q, k). One paricularly ineresing case occurs when echnological and labour supply shocks are boh generaed by saionary, mean revering processes, i.e. here are a leas wo coinegraing relaions among he variables in (u, w, q, k), he unemploymen equaion (8) gives (one of he) coinegraing relaions: u ( θ + γ 2 ) w + γ 2 ( π) q + γ k = ξ ζ ~ I(0) () An equaion like () is an example of a relaionship beween he variables in (u, w, q, k) ha we hypohesise exis among he observed ime series counerpars of hese variables in he wo counries concerned. As he logic of he preceding model suggess, however, () need no be he only coinegraing relaion beween he variables; ineresingly, wo pairs of variables in () could be coinegraed, so ha () in effec represens a linear combinaion of hese wo saionary variables or coinegraing pairs. 6 There will be a unique soluion, provided he deerminan of he srucural marix linking he four endogenous variables ogeher in he model srucure is non-zero, see Jacobson e al. (996) for an analogous condiion (p. 5, where hey denoe he deerminan by ψ). 7 Noe ha a vecor of consan is missing from he soluion (0), since we have absraced from he relevan consans in developing he heory. 5

18 3 Empirical analysis of he Finnish and New Zealand daa 3. Economeric preliminaries: coinegraion analysis In our saisical analysis we are mainly be ineresed in he long-run comovemen of unemploymen, real (consumpion) wages, capial sock and erms of rade. The main reason for focusing on his paricular variable se is he desire o combine flucuaions or shocks predominanly a business cycle frequencies (erms of rade movemens) wih shocks o poenial oupu (evoluion of he capial sock) o ge a quaniaive esimae of heir (join) conribuion o he rise in he observed unemploymen rae in hese wo small open economies. Boh of hese economies are cyclically sensiive and in boh of hem major changes have aken place, suggesing ha he longer-run growh performance of he economies may have been affeced. In New Zealand measures o increase exernal compeiion or measures o improve he operaion of he labour marke have been aken, while in Finland major exernal shocks, he collapse of he rade wih he former Sovie Union, impinging on he economy have occurred. Furhermore, Finnish growh policy in he pas has resuled in inefficiency hrough over-invesmen, 8 which has cerainly conribued o explaining he observed decline of he capial sock in he 990's afer he crisis se in. We use coinegraion analysis o model he possible long-run relaionship beween hese variables. To his end, consider he four-dimensional vecor ime series X = (u, w, q, k ), where u, w, q and k denoe, respecively, log of he unemploymen rae, real consumpion wage, erms of rade and ne (business) capial sock. A saisical model for he vecor ime-series X, he componen series of which are assumed o be I()-processes, is provided by an unresriced vecor auoregression of lengh k,var(k) X = Π(L) X + ε (2) where Π(L) = + L k Π Π2 Πk L, ε NID4(0, Ω) for fixed iniial values of X k+,..., X 0. In (2) L is he lag-operaor L j X = X j. The hypohesis of ineres is he number of possible coinegraion relaions among he componen series of he vecor ime series X. We follow Johansen s (988, 99) 9 FIML approach o he saisical inference in coinegraed sysems 20 here. The procedure involves esimaing a VAR(k) by maximum likelihood and sars 8 See Pohjola (996). 9 See also Johansen and Juselius (990, 992). Johansen s book (995) provides a unifying reference. 20 Full efficiency of he Johansens s procedure may well enhance is araciveness in he approach o he saisical analysis of coinegraed sysems. However, o our minds he fac ha i provides a unified framework for inference in such sysems is perhaps a more compelling reason o follow he procedure. Inder (993) provides a comparison of some of he differen mehods of esimaing long-run relaionships in economics. 6

19 by ransforming he VAR(k) in (2) ino is equivalen vecor error correcion form (VECM, for shor): 2 k X = Π X + Γ X + ε (3) where k i i i= Π = Πi I4, Γi = Π j. i= k j=i+ The number of coinegraion relaions depends on he rank, r, of he long-run Π marix in he known way; if X is no a difference (r = 0) or level (r = 4) saionary VAR(k), hen here are exacly r, 0 < r < 4, coinegraion relaions among he four variables. This is equivalen o saying ha he series can be joinly characerized by 4 r common or sochasic rends, 22 i.e. he vecor represenaion of hese series has 4 r uni roos. The hypohesis ha here are r coinegraion relaions in he sysem, 23 H(r) for shor, can hus be saed formally as a reduced rank condiion on he marix Π, 24 Π = α β (4) where α and β are (4xr) marices of full column rank, called he (facor) loading marix and he marix of coinegraing vecors, respecively. Since he hypoheses form a sequence of nesed hypoheses (a lower dimensional space is embedded in a higher one), he idea is o es for a increasing number of coinegraion vecors in he sysem, saring from he hypohesis ha r = 0. Specific hypoheses abou he long-run coinegraing vecors β, 25 which can be formalized as linear resricions on β, can be formulaed and esed wihin he Johansen framework. 26 Analogously, we can impose and es resricions on he 2 A coinegraed sysem can, under mild regulariy condiions, be equivalenly represened as a VECM. This equivalence is he resul of he Granger s represenaion heorem (see e.g. Granger and Engle, 99, or Johansen, 995). 22 Johansen (995, p. 4) emphasizes he relaionship beween he error correcion and he common rends model: hey are complemenary in he sense ha he wo approaches are mahemaically equivalen. They could, of course, appeal o differen ypes of inuiion. Sock and Wason (99) propose ess ha can alernaively be viewed as ess of he number of common rends, linearly independen coinegraing vecors or auoregressive uni roos of he vecor process. See also Warne (990a,b, 993). 23 Only he dimension of he coinegraion space will be esimaed by he Johansen s procedure. The se of vecors ha generae his space will no be idenified by he procedure, i.e. he se is no unique, since a non-singular ransformaion of he se of coinegraion vecors will do as well and will amoun o represening he coinegraion space in a differen co-ordinae sysem. 24 Anderson (984) is he relevan reference for he heory underlying reduced rank regressions. 25 The esimaes of he long-run parameers βˆ are asympoically mixed Gaussian (see e.g. Johansen, 995, ch. 5), which has implicaions in he conex of he discussion on sandard confidence inervals buil upon he coinegraing vecors laer in he ex. 26 We could, in paricular, es for he saionariy of any of componen series by esing wheher he uni vecor (0,...,,..., 0) ( in he i h place) belongs o he coinegraion space. 7

20 loading marix α. 27 Perhaps he mos ineresing of he hypoheses concerning he loading marix relaes o he concep of weak exogeneiy, which, if i holds for a subse of he variables, means ha inference abou coinegraion (including loadings) in he parial sysem no involving weakly exogenous variables is valid. 28 Weak exogeneiy can be a very useful propery of a sysem, especially when i is easier o model he condiional model of he endogenous variables given he exogenous variables saisfacorily and he marginal disribuion of he exogenous variables shows irregular behaviour, which is difficul o model using a VAR. Johansen has proposed wo es saisics for esing for he number of coinegraing relaions and general linear hypoheses, he maximum eigenvalue and race ess respecively. The laer is based on he sum of he p r smalles canonical correlaions (or eigenvalues) beween (sandardized) residuals from projecing changes in X and he level of X on lagged changes in X. The asympoic disribuion heory is non-sandard, and abulaed disribuions have o be consuled. 29 The (asympoic) χ 2 disribuion heory can be, however, invoked when esing linear resricions on he coinegraing vecors. Analogously, resricions on he loading marix can be esed comparing he esimaes of he eigenvalues in he cases when α is resriced and unresriced. Inference in hese ess relies on a χ 2 disribuion Esimaion resuls for Finland Semi-annual daa for Finland are used covering he sample period In general, i is difficul o choose he appropriae periodiciy for he daa. Quarerly daa end o have a high level of noise and shor-run dynamics can obscure he more fundamenal analysis we are concerned wih here. Semi-annual daa, however, are much more sable. Since boh annual and semi-annual daa provide similar oucomes we repor he semi-annual resuls o minimize any loss of informaion. The variables included in he empirical analysis are, as explained earlier, he logarihm of he rae of aggregae unemploymen (u), real consumpion wage (he raio of average earnings o he CPI, 990 = 00, w), erms of rade (raio of expor prices o impor prices, 990 = 00, q) and ne capial sock in he business secor (k). 27 The marix α gives (facor) loadings along he saionary dimension of he coinegraed sysem. Hence, loadings along he non-saionary dimension, denoed by α], i.e. coefficiens of he common rends belong o he orhogonal complemen of he subspace generaed by he columns of α, i.e. α α] = 0. Coinegraing vecors and common rends are obained from he soluion o he same eigenvalue problem, he former corresponding o he r larges and he laer o he p r smalles eigenvalues, so hey are esimaed in a dual manner in he Johansen s coinegraed VAR conex (see Johansen, 995, secion 8.3). 28 For a more horough analysis of an I() model, see Johansen (995, especially ch. 5); ch. 8, on he oher hand, deals wih weak exogeneiy and valid condiional inference. 29 See e.g. Johansen (995, ch. 5). 30 Johansen (995, ch. 8). 8

21 3.2. Uni roo esing on he Finnish daa In conducing he uni roo es, lags up o 4 (i.e. wo years) were included. The maximum of four lags appeared o be sufficien o filer ou mos of he residual auocorrelaion presen in he residuals afer fiing an AR-process o he ime series. Appendix conains summary ables from he uni roo esing. Table. summarizes he resuls of he Augmened Dickey-Fuller ess for Finland. Even hough he formal es suggess a uni roo in he (log) level of he variables in he sysem, he unemploymen rae as well as he capial sock appear borderline cases, bu in differen direcions. Whereas he log of he unemploymen rae comes close o being saionary, he log of he capial sock appears o come very close o being an I(2) process! In paricular he null of a uni roo in he DGP for he rae of unemploymen canno be rejeced when more lags are included in he ADF es. This may be a reflecion of he reducion of power in uni roo esing when he number of lags is increased. 3 On he oher hand, he sum of he esimaed AR-coefficiens, he bea Y_ column, in he case of he log of he capial sock appears o be large in comparison o he corresponding ones of oher variables in he sysem, and even exceeding one, once lags are added. 32 Furher 3 The argumen ha unemploymen rae canno have a uni roo, because i is bounded by 0 and so ha random labour marke shocks would drive he unemploymen rae o 0 or one wih he passage of ime (see e.g. Karanassou and Snower, 997a, p. 4 fn. ) needs qualificaion. Firs of all, unemploymen rae canno be an unresriced (linear) random walk or Brownian moion because of he bounds. Bu i can be regulaed Brownian moion (or even a Brownian bridge). Hence, here can be a uni roo in he unemploymen rae, bu is flucuaions are consrained by barriers, mos plausibly by reflecing barriers, since absorbing barriers would imply ha he unemploymen rae says a a paricular level, once i reaches ha level. These barriers can e.g. reflec he inernal workings of he economy iself or hey can resul from policy regulaion. The exisence of such barriers raises he possibiliy of a non-linear relaionship beween he unemploymen rae and is fundamenal deerminans. Alernaively, here could be non-lineariies in he process generaing observed unemploymen e.g. regime shifs so ha observaions on he unemploymen rae look favourable o a uni roo, in he conex of uni roo esing. A a general level, however, he unemploymen rae is no much differen from many oher economic series, in he sense ha hese series canno sricly speaking be modelled as (symmeric) unresriced Brownian moion a leas because of he exisence of non-negaiviy consrains, which are ypically ignored in he uni roo ess of hese series. Consumpion, oupu, prices ec. are subjec o non-negaiviy consrains and canno hus be, sricly speaking, modelled as (symmeric) unresriced Brownian moion. In hese circumsances uni roo economerics is implicily assumed o give a reasonable basis for saisical inference in he conex of (saisical) modelling hese series. A similar line of reasoning is applied in he presen conex. 32 The noaion used in PcGive 9.0 for Windows (996) by Hendry and Doornik may cause confusion a his paricular poin; p. 22 informs he reader ha he bea Y_ is he coefficien on he lagged level: β while he es equaion is given in equaion (6.7) p. 2: x = α + µ + βx - + Σγ i x i + u. Our Table. is represenaive of he oupu produced by PcGive; for example β equals in a DF-es (number of lags equals ) for a uni roo in he unemploymen rae, which seems o imply ha he esimaed AR()-coefficien, ρˆ =+ βˆ = =.847! Clearly, hen, bea Y_ in he PcGive oupu able from a uni roo es is no he esimaed β in he above ADF es equaion. Raher, bea Y_ equals he sum of he esimaed AR-coefficiens from he equaion, as argued in he main ex. An esimae of he β is obained by subracing one from bea Y_, ˆβ = bea Y_. 9

22 evidence is provided by Table.2, which ess for a uni roo in he firs difference of he series (i.e. growh raes). 33 A face value, Table.2 seems o sugges ha here is also a uni roo in he growh rae of real wages and he capial sock. However, he β-coefficien on he relevan lagged difference for he growh rae of real wages is 0.48 and 0.42 a lags 3 and 4 respecively and he ADF-es suggess a uni roo in he process generaing growh in real wages. For he capial sock, on he oher hand, he β- coefficiens are higher, bu sill well bounded above by 0.9. This suggess ha here is a subsanial amoun of auocorrelaion in he growh rae of he capial sock or ha he growh rae of he capial sock series is relaively smooh. 34 Furher specificaion ess 35 sugges he following observaions; (i) general as well as ARCH-ype heeroscedasiciy is presen in he residuals from he ADFes equaion, which canno be removed by he usual procedure of adding in furher lagged differences. (ii) graphical inspecion indicaes ha here are wo large residuals around he year 990, which give rise o deviaions from normaliy in he form of hick ails and skewness o he lef. These deviaions from he ideal condiions underlying he ADF-ess end o reduce he efficiency of hese ess in finie samples. 36 Overall, hen, he decision o rejec he hypohesis of uni roo nonsaionary growh raes of he variables in our sysem should be viewed wih cauion, especially because of he es resuls for he growh rae of he capial sock. Wih his in mind, we will coninue o he coinegraion analysis under he assumpion ha he vecor ime series X = (u, w, q, k ) is generaed by an I() vecor process Coinegraion analysis of he Finnish daa Johansens s procedure was followed o es formally for he dimension of he coinegraion space as well as o run weak exogeneiy ess on some of he variables, mos noably he capial sock, w.r.. he parameers of he coinegraion relaionship among four variables in our sysem. Appendix 2A gives he relevan 33 The uni roo es for he erms of rade is in line wih (he exensive lieraure on) esing he validiy of PPP (purchasing power pariy) in he sense ha he es here suggess ha deviaions from PPP are nonsaionary (see Rogoff, 995, for an excellen survey on PPP and long-run real exchange raes). 34 The shape of he esimaed specrum for he growh rae of he capial sock also confirms ha here is subsanial auocorrelaion in he series. The esimaed specrum for he growh of he real wages, on he oher hand, is U-shaped, where he minimum occurs approximaely a frequency 3/4, implying ha cycles shorer han /3 years make a considerable conribuion o he variance of he growh rae of real wages. 35 Available from he auhors upon reques. 36 We will reurn o he possible I(2) of he capial sock in he conex of he coinegraion analysis, where he growh rae of he capial sock is also used insead of he log-level. As far as he oher diagnosics are concerned, we checked he oucome from he ADF es by including wo impulse dummies in he es equaion o miigae he effecs of he ouliers around 990. The -saisics, β, did generally rise a various lags, even o he exen ha a lags 3 and 4, he null of a uni roo was rejeced a he 5 % significance level. The 0 % criical value for he ADF es (from McKinnon, 99), on he oher hand, is around 3.69, which ends o lend suppor for he rejecion of a uni roo in he growh rae of he capial sock, bu does no, unforunaely, fully susain he conclusion in he main ex ha he growh rae of he capial sock is (rend) saionary. 20

23 summary ables from he (unresriced) coinegraion analysis. 37 According o Table 2.b, boh he maximal and race es, in he uncorreced form in paricular, seem o sugges ha he coinegraion rank be, i.e. here is evidence of one coinegraion relaionship beween he unemploymen rae, real consumpion wage, capial sock and erms of rade in Finland. The unresriced esimaes of he β-marix as well as of he loading marix (vecor) α corresponding o he proposed coinegraion vecor maximal eigenvalue or canonical correlaion (emboldened) are Table 2.c. Given ha he coinegraion dimension is one, he esimaed coinegraion vecor appears o be reasonable from an economic poin of view. In paricular, if we could conclude ha i is an unemploymen equaion, he signs of he individual coefficiens are consisen wih heory, alhough hey are perhaps a lile oo large (in absolue value). Overall, hen, Table 2.c seems o sugges ha he following linear combinaion of he unemploymen rae, real consumpion wage, capial sock as well as he erms of rade in he Finnish daa, normalized by he unemploymen rae, ECM = ˆ X β = u 3.23 w +.53 k +.63 q (5) (where he ha signifies esimaed ), is saionary, i.e. I(0). The corresponding sandardized (facor) loadings in Table 2.d, which inerpre he effec of he disequilibrium error correced for lagged differences, 38 indicae sable error correcion dynamics. The srucure of he esimaed loading marix has an ineresing srucure. In he presen conex we can wrie he VECM as X FI = u w k q = ( u j= Γˆ X j FI j w + εˆ FI k +.626q ) (6) 37 A baery of specificaion ess were run on he ECM represenaion underlying he coinegraion analysis. The ECM of he VAR(4) capures mos of he observed variaion in he growh raes of variables (i.e. x ); no residual auocorrelaion is lef in he equaions; a small ARCH-effec a lag 2 is presen in he residuals for he growh rae of capial, bu no more general form of heeroscedasiciy can be deeced from he residuals. The null of normal residuals, however, is rejeced in he case of he growh rae of unemploymen and capial sock. I appears from he graphs of he residuals ha his sems mainly from skewness. The sample disribuion of unemploymen residuals appears o be slighly posiively skewed due o he sharp increase in he observed unemploymen rae in Residuals from he growh rae of he capial sock appear o be a mirror image of hose of he unemploymen rae; i.e. heir sample disribuion is skewed o he lef. 38 And hence involves all he parameers of he model. 2