The usual neoclassical model of labor supply and employment determination has been based in closed economy models. This paper studies the effect of introducing open economy features on the determinants of equilibrium employment. It derives the long run employment level as a function of the real wage, real interest rate and real exchange rate from a standard open economy optimizing representative agent model. The paper tests the steady state solution of the model using US and UK data and, in order to avoid the Lucas' critique, it tests for the superexogeneity of the interest rate and exchange rate. The evidence shows a significant impact of the real exchange rate, real interest rate, and real wage only for the US, where it is also robust to the Lucas' critique.
This paper presents a theoretical and empirical analysis of the intertemporal optimising agent model in which we introduce imported goods and capital flows and hence the effect of the real exchange rate. The employment behaviour derived from these kinds of models lies at the heart of labor market fluctuations, and cyclical fluctuations in employment are one of the leading forces behind the business cycle.1 The hypothesis gained strength in the literature after the seminal paper of Lucas and Rapping (1969). The main idea is that workers, as rational maximizing agents, compare actual and expected future real wages and adjust their labor supply accordingly. If, due to an increase of the real interest rate, workers expect the future real wage to decrease relatively to the present real wage, they increase their labor supply and vice versa. Given the consumer producer assumption of the model, changes in the interest rate would imply changes in equilibrium employment.
The optimising agent model has been tested exhaustively. Just to quote a few references, the findings of Hall, 1980, Abowd and Card, 1987, Alogoskoufis, 1987a, Alogoskoufis, 1987b, Dutkowsky and Foote, 1992, Dutkowsky and Dunsky, 1996, Mulligan et al., 1999 and Ziliak and Kniesner, 1999 support its hypothesis. While Card (1991) in a survey of the microeconometric literature, Altonji, 1982, Altonji et al., 2002 and Mankiw et al., 1985 present evidence against the model.
However, the theoretical and empirical work done in this area has been based on closed economy models.2 This paper is a first attempt to analyse the consequences for employment of setting the intertemporal optimising agent model in an open economy context. We do so by setting up a standard open economy model in which the derived labor supply and employment is a function not only of the real wage and the real interest rate, but also of the real exchange rate. By testing empirically the long run predictions of the model, the paper is able to assess the relevance of the introduction of the real exchange rate. Moreover, it allows us to examine the direct impact of the real exchange rate on employment. As we shall see, the open economy model provides a better specification of the equilibrium employment function. Some papers on the ‘new open economy macroeconomics’ tradition such as Benigno and Thoenissen (2003) have analysed the impacts of real exchange rates on labor market performance using calibration methods. Others such as Campa and Goldberg, 2001, Gourinchas, 1999 and Klein et al., 2003 have estimated the impact of the real exchange rate on the US and French labor markets finding significant re-location effects. In this paper, we propose a simple but appealing set up based on the intertemporal optimising agent model that extends the original contribution of Lucas and Rapping (1969) to analyse the possible effects of exchange rates on employment performance.
The paper is structured as follows. Section 2 presents the representative agent model of an open economy, where the equilibrium employment function is derived as a function of the real wage, real interest rate and real exchange rate. Section 3 presents the econometric estimation of this function for the US and the UK economies. The concluding remarks appear in Section 4.
Most of the theoretical and empirical literature on the optimizing intertemporal model of economic fluctuations has been based in closed economy models. This paper studies the implications of this model in an open economy. It presents a standard representative agent open economy model in which the long‐run equilibrium employment level is derived as a function of the real wage, real interest rate and real exchange rate. The expected effect of these variables is in line with the neoclassical growth model. Increases in the real wage and real interest rate lead to increases in employment. The impact of the real exchange rate is ambiguous.
We test the steady state (equilibrium) solution of the model using time series data for the US and the UK for the last thirty years. The results are consistent with the model's predictions for the US case. We find positive impacts of real wages and the real interest rate and a negative and significant impact of the real exchange rate. These results are not confirmed for the UK case. In order to avoid the Lucas critique, tests for the superexogeneity of the interest rate and exchange rate are also carried out. Overall, our empirical evidence is supportive of the open economy version of the intertemporal optimization model and robust to the Lucas critique only for the US economy.
