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Primary commodity prices and the OECD economic performance
EUROPEAN FS%vc ELSEVIER
European Economic Review 39 (1995) 83-98
Primary commodity prices and the OECD economic performance Annalisa Cristini * Department
of Economics, University of Bergamo, Piazza Rosate 2, 24100 Bergamo, Italy Institute of Economics and Statistics, Oxford UK
Received September 1992; final version received October 1993
Abstract The relationship linking primary commodity prices to the OECD economic performance is analyzed by explicitly accounting for the presence of a two-way causality. The macroeconomic model is built on a relatively small number of equations which represent the interplay of five markets: primary commodity-, financial-, OECD labour-, OECD and LDC product market. The difference between primary commodity- and manufactured good price formation is emphasized. Quantitative results are provided on the basis of historical estimations and dynamic simulations. Keywords:
Primary commodity prices; Economic performance; OECD
JEL classification:
E17; E24; E31; E44; F4
1. Introduction Since the 1970’s oil shocks, the formation of primary commodity prices, as well as their impact on the economic performance of the industrialized economies, has been the object of many studies; however, the usual approach was to address
* This paper is based on my Oxford D.Phil thesis for which I am most grateful to my supervisor, Steve Nickell. The Institute of Economics and Statistics of Oxford, the Centre for L&our Economics, the London School of Economics, the Italian Ministry of University and Research and Bergamo ‘Unione Industriali’ are acknowledged for financial help. I also wish to thank David Grubb for providing some of the data. The usual caveats apply. 0014-2921/95/$09.50 0 1995 Elsevier Science B.V. All rights reserved SSDI 0014-2921(94)E0124-4
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Economic Review 39 (1995) 83-98
these two topics separately, thereby disregarding potential feedbacks existing between them. ’ The objective of this paper is precisely that of appraising this overlooked two-way causality using a relatively simple model. The latter builds on two observations; the first one is that the industrialized economies, taken together, basically represent the demand side of the primary commodity market; hence primary commodity prices are endogenous in a model which takes the industrialized countries as a single block. The second observation arises from the difference existing between the bahaviour of primary commodity prices and that of manufactured good prices; such a difference is explicitly accounted for by specifying two separate mechanisms of price formation. The layout of the paper is the following. The theoretical model is outlined in the next section, while its working is described in Section 3. Sections 4 and 5 report estimation results and simulation exercises. Conclusions are drawn in the final section.
2. The model
The model (Cristini, 1989) views the OECD as a unified block which interacts with the rest of the world via the primary commodity market and the capital market. Since all intra-block trades are purged by construction, the block’s imported inflation is fully accounted for by the variations of the average import price or the average primary commodity price index as long as the latter is a good approximation of the former. ’
2.1. The economy of the OECD block
The which product and on 1
economy of the OECD block builds on the Layard-Nickel1 (1986) model has been successfully applied to several OECD economies. The OECD market is assumed to be imperfectly competitive; firms forecast demand this basis set employment and output prices. The general form of the price
Beenstock (1987~1, b) is an exception. ’ Cristini (1989) shows that the real import unit value is directly proportional to an aggregated real primary commodity price index as long as: 6) the proportion of imported primary commodities relative to imported manufactured goods is greater than the proportion between the same class of goods in gross output and (ii) these proportions are constant. Although from 1970 to 1985 industrialized countries have increased their self-sufficiency in primary commodities while tending to import a larger percentage of manufactured products from developing countries, the proportionality between the primary commodity price index and the import price index still holds.
A. ~ris~ini/E~ro~an
Economic Rmiew 39 (1995183-98
equation, which is determined by substituting revenue function, is the following: 3
85
expected demand into the marginal
~-w=[FD(~,(p-p~),Cb~,a,(k-1),(w-w”),r).
(I)
The employment equation is obtained by using the marginal revenue condition in the production function, which is in terms of value added and linearly homogeneous in the logarithms: n-k=iW(/&,(
W-P),
(w-w”),
6 r).
(2)
Both equations are fairly standard except for the real interest rate, which is allowed to affect the marginal revenue condition on the assumption that it may influence at least one of the following factors: the cost of working capital; the discount rate and hence those decisions involving a comparison of the firm’s profits at different times; the elasticity of demand and, hence, the profit maximizing mark-up itself. The labour market is characterized by the presence of unions with which firms bargain the wage; 4 the product-wage equation is the standard one obtained by re-arranging the first-order conditions of the Nash maximand: 5
u7 Pt fax, (PO -P),
(Pn 7)).
(3)
In the empirical version of the wage equation, the number of industrial conflicts, normalized to the number of employees, approximates union power. The model behind the conflict function, which augments the representation of the labour market, assumes that conflicts arise whenever the desired real wage turns out to be higher than the actual wage by an amount greater than the flow cost of a strike (Cristini, 1989).
2.2. The world markets The OECD block interacts with world-wide or inter-block markets where financial assets and primary commodities are traded and their prices are set.
3
Unless otherwise specified, all variables are in log. The symbols are defined as follows: p is the GDP deflator, w is nominal wage, y is a potentially cyclical mark-up, a is labour augmenting technical progress, k is capital, 1 is labour force, n is employment, r is level of the real interest rate, Cp are deviations of real demand from potential output which, in turn, is reached when employment equals the labour force; superscript ‘e’ indicates expectations. ’ Other relevant wage-setting mechanisms (market, efficiency wages) can be derived as special cases of the bargaining specification (Johnson and Layard, 1986). ’ In Eq. (3f, UP is union power, p is the replacement ratio, rax are employer and employee taxes, p0 and p, are oil and non-oil commodity prices, respectively.
A. Cristini / European Economic Review 39 (1995) 83-98
86
Unlike manufactured good prices, which are mainly cost-determined, primary commodity prices, since they are usually set in competitive markets (Labys, 19801, are expected to absorb many of the effects induced by variable economic conditions and to be highly and positively responsive to excess demand, at least in the short run. In addition, it has been argued that homogeneity and storability, which characterize such commodities, may make them sufficiently similar to financial assets. 6 To test this hypothesis the rate of interest is also allowed to affect the price of primary commodities via a speculative storage function. Finally, in order to avoid some of the usual estimation problems, the empirical version of the commodity price function 7 is derived from the reduced form of the structural model (Gilbert and Palaskas, 1989): 8
+“8&-l])’
- [ u6rf-1 + '7kl
(4)
Eq. (4) behaves in accordance with an error-correction model; the variables appearing in the curly brackets are expressed in real terms and represent the long-run equilibrium relationship. The real interest rate is set in the financial market as the price which equates demand and supply of loanable funds. The private sector requirement is mainly directed to investment plans whereas the funds collected by the public sector are used to finance outstanding debts. Supply comes from accumulated wealth, e.g. OPEC wealth and savings. Real primary commodity prices may enter the real interest rate equation as long as commodity prices are used as demand indicators and/or there is some substitutability between financial and commodity assets 9: ,-= R(@-P), u,z,
(P,-PL
(S-P>>
(b-p)>
(PO-P)?
Y*)
(f-p), (5)
The representation of the international financial market also includes a function describing LDC external debt, which has been particularly relevant at least since the debt crisis of the early eighties.
6 In particular the equivalence with financial assets depends on the extent to which primary commodities are stored; in this regard, since the occurrence of stock outs is not allowed in linear models, such models tend to yield an excessive degree of assimilability (Deaton and Laroque, 1990). ’ We do not attempt to describe the oil price as it has been highly dependent on OPEC cartel decisions. The oil market regained some competitiveness only from the mid eighties. ’ In Eq. (4) L is the nominal interest rate, L indicates empirically chosen distributed lags and 5 and 5 are demand and supply indicators, 9 In Eq. (5) m is money supply, b is OECD government debt, f is OPEC wealth, y* is LDC GDP and s is LDC external debt.
A. Cristini/European
Economic Review 39 (1995) 83-98
87
The accumulation of debt over time depends both on the real interest rate and on the primary debt; in addition, the present value of the latter determines the level of sustainable debt and thereby adds a long-run solution to the short-run accumulation relationship (Dornbusch, 1986). The non-interest debt component, though affected by domestic policies, has been largely shaped by the developments of the world economy, the relevant indicators of which we take to be the terms of trade vis-a-vis OECD and vis-a-vis oil exporting countries and the rate of OECD unemployment: s-P=S(r,(P,-P),(P”-P,),U,Y*).
(6)
In order to avoid unstable coefficients, which may arise if the debt crisis of the early eighties caused a change of regime, the impact of each explanatory variable is allowed to change between the pre- and the post-default period. 2.3. The developing country block The non-OECD block is represented by an aggregated developing country GDP equation. The latter can be thought of as a reduced form of an IS/LM type system: (7)
3. The working
of the model
The model is composed of Eqs. (11, (21, (31, (41, (5), (61, (7) plus the equation determining the number of industrial conflicts (NC). In addition, the rate of unemployment is linearly linked to the log of employment and labour force by the relationship: U = 1 - n. In the short run wage and price forecasting errors generate nominal inertia which produces a gap between the real wage and the price mark-up over wages. The gap is proportional to the rate of inflation present in the system which in turn must be consistent with the exogenously given level of real demand. Hence, when implemented dynamically, the system solves for W, p, U, pn, r, s, y* and NC while deviations of real demand from potential are taken as given. In the long run, expectations are fulfilled; the price mark-up over wages coincides with the real wage and the system may solve for an additional variable, i.e. the level of demand. In consequence the model solves for (w - p>, U, C#I, (p, - p), r, (s - p), y* and the number of conflicts normalized to the number of employees. The long-run system encloses two fundamental relationships linking commodity prices to the OECD rate of unemployment. One of these relationships underlines the primary commodity market equilibrium, the second one the equilibrium in the Northern economy. In a (p,, -p&U space, the intersection of the two
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A. Cristini/European
Economic Review 39 (1995) 83-98
ju*
IU
l U
Pn-P ---_.
--__..j w--.._.____
_______.------
_____------
north -A___ , _.___=-=p7<:
Fig. 1. Long-run
________---------.._____
south --..__
equilibrium.
lines determines the equilibrium real price of primary commodities and the equilibrium rate of unemployment (Fig. 1). Notice that the North line is obtained for any given real wage and is described, in the (w -p&U space, by the intersection of the real wage and price equations. lo All points on the North line are points of equilibrium for the North: the rate of inflation is constant and unemployment is a NAIRU. Above and below the North line the rate of inflation is, respectively, increasing and decreasing. Suppose that the North follows an expansionary policy in order to lower the rate of unemployment to U’ below U*. Depending on the relative inertia of wages and prices, real wages will set at some new point between C and D, thereby initiating a positive rate of inflation. In addition, since the expansionary policy creates extra demand for primary commodities, the price of these increases correspondingly up to point B. Such a rise, by moving the wage line rightwards, sharpens inflation, which becomes proportional to the segment ED rather than CD. If the expansion is ‘once and for all’ and money supply is not accommodating, real money balances effects are likely to bring the system back to equilibrium. Alternatively, one may think of preserving the lower rate of unemployment and decreasing inflation by moving the wage line leftwards towards point D. A well-known way to achieve such an objective is by appreciating the OECD currency relative to the LDC currency; however this policy is detrimental for the non-OECD block and likely to involve large balance of payments deficits in the North. If the demand or supply shock is permanent, then the North and, possibly, the South line, depending on the type of shock, may shift permanently and determine a new long-run equilibrium. In this regard it is instructive to point out
lo Alternatively the latter relationship can be obtained from the unemployment the price equation provides the corresponding level of real demand.
equation.
In this case
A. Cristini / European Economic Review 39 (1995) 83-98
that, for any given South line, the flatter the North line is, the more responsive the long-run rate of unemployment to any given shock.
4. The estimated
89
is
model
All equations are estimated simultaneously using Three-Stage Least Squares; the methodological procedure accords with the ‘general to specific’ approach. Nominal variables are all expressed in OECD currency, where this is obtained from the basket of currencies of the countries entering the block; l1 similarly, the interest rate is obtained by weighted average of national interest rates, the weights being the GDP shares. The eight estimated equations are reported in Table 1, Appendix A. 4.1. The OECD product and labour markets The way the model features in its empirical version defines specific links between the various markets which delineate the propagation mechanism. A direct link between the OECD economy and the financial market is revealed by the presence of the real interest rate both in the price equation and in the employment equation. In particular, in response to 1 p.p. rise of the real interest rate, the long-run employment falls by 0.62% while the long-run price mark-up over wages rises by 0.49%, ceteris paribus. On the other hand, the wage behaviour is not directly affected by the real interest rate; instead, as a result of the import price component of the wedge, it joins the OECD economy to the primary commodity market. l2 In particular, wages respond to an overall index of primary commodity prices because a distinction between oil and non-oil prices was not empirically successful 13. Labour and product market interact closely with each other though the real wage responds to the rate of unemployment with a three-year delay; there is, however, an indirect but current effect of the rate of unemployment on wages which works through the conflict equation which, in turn, contributes to
l1 In adopting this type of aggregation, rather than, for example, converting all nominal variables into US dollars, we follow the IMF which is the main source of our data. However specified, currency aggregation may be limiting in so far as the variability of the exchange rates of OECD currencies against the dollar may have distribution effects within the OECD. Similar effects may also be relevant to non-OECD economies. See Cristini (1989) for a detailed description of the variables. I2 In the price equation primary commodity prices, which might have affected the mark-up, turned out to be statistically insignificant (t = 0.6 for pa and t = - 1.6 for p,). I3 The overall primary commodity price index is a time varying weighted average of oil and non-oil prices. Gilbert instead (1991) finds that the consumer price inflation responds more rapidly to oil than to non-oil prices.
90
A. Cristini / European Economic Review 39 (1995) 83-98
determine an overall 2.6% fall of the long-run real wage in response to a 1 p.p. rise in the rate of unemployment. l4 The number of conflicts, which exercise a positive pressure on the real wage, are reduced by persisting unemployment which, by signalling bad market conditions, increases the vulnerability of workers and persuades them to reduce their industrial action; this finding is in line with most of the empirical literature on strikes. l5
As appears from the real interest rate equation, the link between the OECD economic activity and the real interest rate runs both ways as the rate of OECD unemployment depresses the rate of interest; on the other hand the South’s economic activity is apparently irrelevant to the financial market: indeed, as is clear from the estimated LDC GDP regression, the OECD rate of unemployment well summarizes the state of both economies. The real interest rate is directly affected by the primary commodity market; in particular the positive coefficients of both oil and non-oil primary commodity prices are likely to capture restrictive policies in the presence of inflationary pressure. A rise in debt financing relative to money also determines a rise in the real interest rate without a significant difference for the debtor country. The presence of the rate of unemployment in the estimated primary commodity price equation confirms the two-way relationship between OECD demand and primary commodity market; the negative influence of the rate of unemployment is quite pronounced in the short run but relatively small in the long run when a 1% fall of U raises real commodity prices by around 2%. I6 On the other hand, the interest rate has no obvious effect which substantiates the results of other studies (Enoch and Panic, 1981; Winters, 1987; Gilbert and Palaskas, 1989; Vines and Ramanujam, 1988) and suggests that primary commodities are likely to have features which distinguish them from normal financial assets. ” The LDC debt equation does not reveal significant regime changes but turns out to be highly responsive to a deterioration of the North economic performance, given the latter’s level of money supply; debt can fall only if the trend GDP rises
l4 Notice that the significance of the rate of unemployment in the wage equation substantiates the existence of an OECD Phillips curve (see Beckerman and Jenkinson (1986) for a different conclusion using country data). I5 Ashenfeher and Johnson (19691, Mayhew (1978), Paldam (1983,1989), Paldam and Petersen (1982). ” Higher elasticities are obtained by Flesing and Van Wijnbergen (1985) and Enoch and Panic (1981). t7 If L.DC debt is included as an additional regressor, as suggested in Gilbert (1989), the coefficient is unexpectedly positive and the specification fails the parameter-stability test.
A. Cristini/European
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Economic Review 39 (1995) 83-98
4
5
6
7
8
9
91
lo
wz
Fig. 2. Estimated long-run equilibrium.
relative to the actual one. l8 The latter is also strongly economy: a 1 p.p. rise of the OECD rate of unemployment 3% of LDC GDP.
linked to the North implies a fall of over
4.3. The estimated long run The empirical North and South lines are derived using the steady-state solutions of the estimated equations. The South line actually reduces to the non-oil primary commodity price equation. The North line is obtained by equating the real wage equation with the price mark-up over wages and then replacing the real interest rate and the number of conflicts using the relevant equations. l9 In order to analyze the role of the international transmission mechanisms, two restricted versions of the complete model (model 1) have also been considered. In one case, the South block, represented by the LDC debt and GDP equation, has been exogenized (model 2); in the other case, both the South block above and the primary commodity market have been excluded (model 3). Fig. 2 illustrates the estimated long-run equilibrium. (i) For the period 1961-1984 the estimated equilibrium rate of unemployment is around 7%. An upsurge of the oil price shifts the North line downwards and the South line upwards: if the oil price doubles the long-run rate of unemployment increases by 0.88 p.p. which implies a 2.85% fall of LDC GDP.
‘* Potential LDC GDP (JJ * ) is defined by the estimated time and time squared. I9 The North line is
values obtained
-0.0293~(p,-p)=1.8573+0.259~a-0.542~(k-I)+1.602~fax-0.058~~* +0.028~(b-m)+0.0339~(p,-p)-3.022~U. where all exogenous
variables
are valued at their sample mean.
by regressing
log(y * ) on
+0.003.rime
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Economic Review 39 (1995) 83-98
(ii> The South equilibrium line is invariant to the exclusion of the LDC GDP and LDC debt equations. On the contrary, the North equilibrium line gets steeper. This fall of the North economy responsiveness to changing primary commodity prices is caused by the exclusion of the LDC debt transmission mechanism which, in response to the rise of U following a primary commodity price shock, sets up a positive pressure on the real interest rate and hence an additional rise in the rate of unemployment. This effect dominates the feedback from LDC GDP to the rate of unemployment which, on the contrary, tends to reduce the initial rise of U. This result suggests that the presence of large LDC external debts worsen the negative long-run effects on OECD unemployment (and hence on LDC GDP) caused by oil price hikes or restrictive policies; on the other hand the link between the South GDP and the North economic activity appears to be beneficial for both blocks when hit by bad shocks. (iii) When both the South block and the primary commodity market are excluded, the overall equilibrium reduces to the equilibrium of the North, i.e. a vertical line in the ( pn -p)-U space which can be more interestingly described by the intersection of the price and the wage equations in the (w -p&U space, as in the small open economy case. In line with the literature which emphasizes normal cost pricing procedures, the price line is here flatter than the wage line.
5. Simulations In order to characterize the short-run dynamics of the model, a few simulations are performed 20. The assumption is that we are always in the short run, hence deviations of demand from trend are exogenous while wage and price forecasting errors are present and endogenous. The impact of exogenous shocks on each endogenous variable is measured in terms of the endogenous variable’s deviations from its historical dynamic simulation. Simulations are performed on the last twelve years of the sample and assume a twofold rise of the oil price (see Cristini (1989) for simulations concerning other exogenous variables). The effects of the shock are analyzed for the three different models introduced in Section 4.3: these successive restrictions allow an assessment of how relevant international linkages are in the short run relevance and how they work. The dynamic multipliers of the main endogenous variables are reported in Table 2, Appendix A. 20
In the context of comparative simulations, the Lucas critique (Lucas, 1976) is very relevant. It applies either/both when the reduction process from the Data Generation Process to the statistical model incorrectly conditions on variables which are not weakly exogenous or/and when expectations are mistakenly assumed to be backward-looking though they really are forward-looking. The estimation procedure we have adopted goes some way towards assuring the correctness of the model-reduction process as well as the validity of the expectations assumption. Proper superexogeneity tests would require long computations in view of the number of variables involved in the model.
A. Cristini / European Economic Review 39 (1995) 83-98
93
As far as the rate of unemployment is concerned, the three multipliers show a similar path: they all reach a maximum two years after the shock, then fall and tend to the long-run value quite fast. If the South block is excluded the multiplier decreases, in accordance with the long-run analysis. However, it is the presence of the non-oil primary commodity market which contributes most to rising the rate of unemployment above the initial direct upsurge, implying that the impulses from p, to the wage resistance and r are indeed strong. In model 3 the final rise of U is less than half that implied by model 1; likewise the maximum peak is 0.82 p.p. rather than 1.26 p.p. The real interest rate responds faster than U to the shock: according to model 3, the real interest rate is 2 p.p. higher than its initial value one year after the shock, it falls thereafter and then reaches a stable 1.8 p.p. rise. The inclusion of the primary commodity market increases the variability of the real interest rate multiplier which actually reflects the oscillations that non-oil primary commodity prices undergo after the oil shock. 21 In this case, the multiplier tends to stabilize at a lower value since the impact of a higher rate of unemployment dominates the impact of higher commodity prices. Finally, by including the South block and hence completing the model, the real interest is pushed up by the LDC debt which itself rises sharply in the first three years and finally reaches + 12%. According to model 3, the real wage falls steadily in the first six years after the shock, then stabilizes at just less than - 1%: the wage-resistance pressure is dominated by the rise of U which at the same time weakens union power and reduces conflicts. If the primary commodity market is included the wage-resistance increases considerably and, even if U increases further, it is strong enough to reduce the real wage fall. If the South block is also included, the wage resistance does not increase, but, because of the financial market impact, U rises further; the real wage then falls again though, on average, by a small amount. Finally, LDC GDP falls initially by 4% and then stabilizes at -3%.
6. Conclusions This paper addressed the analysis and estimation of the relationship linking OECD activity and primary commodity prices. The recognition that the link between North and South runs both ways underpins the theoretical model which views the OECD as a unified block interacting with the South through capital and primary commodity markets. The simulation exercises, performed using the estimated model, show that the quantitative response of the North rate of unemployment to an oil price shock is significantly determined by the behaviour of
” The standard deviation of the real interest rate multiplier is lowered to 2.26 in model 3 with respect to 3.57 and 4.71 in model 1 and 2, respectively.
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A. Cristini/European
Economic Review 39 (1995) 83-98
non-oil primary commodity prices which, being pushed up by the oil hike, fuel both wage resistance and real interest rate. On the assumption of doubling oil prices, the overall rise of U reaches a maximum of 1.26 p.p. two years after the shock and decreases thereafter to around 1 p.p. The response of the real wage is determined by two opposite forces: a positive one, induced by the real wage resistance and a negative one, stemming from the rise in the rate of unemployment; they almost counterbalance and leave the real wage practically unchanged. The real interest rate increases by an average of 2 p.p., a third of which is mainly ascribable to the rise in the LDC debt. Indeed, the South is overall badly hit by the oil shock: its external debt rises above 10% while its internal product declines by 4-3%. Primary commodity prices have also a significant impact on the equilibrium values of the OECD rate of unemployment and LDC GDP. In this respect, it appears that the presence of large LDC external debts increases the vulnerability of both economies to negative shocks, whereas the recognition of the interdependence between OECD and LDC economic performances improves their capacity to face and absorb such shocks.
Notes to table A.l: a t statistics in parentheses, The L.M. test is a modified Lagrange Multiplier to test for a first-order autocorrelation in the presence of a lagged dependent variable and IV. We perform the test by first running two-stage least squares and then regressing the dependent variable on the original explanatory variables plus the first lag of the residuals obtained from the initial regression; the set of instruments used is the same in the two regressions. See Breusch and Godfrey (1981). The Chow test for parameter stability (split 1972) is constructed as follows: (SSR, - SSR, - SSR,)/(SSR, + SSR,).(T -2k)/ k, which is distributed as F(k, T - 2k), where SSR,, SSR,, SSR,, are the residuals sum of squares from the regression on the first T observations, the second (T - T,) observations and the complete set of observations respectively. Instruments include constant, trend, dummy, current and lagged exogenous variables and lagged endogenous variables. All variables are as previously defined except for time= linear time trend and dum = dummy equals 1 in 1976-77.
NC,
(w - p),
(n - k),
(p-w),
Dep. var.
1825.76
s.e.
0.014 (2.16)
N; C
R:
s. e. 0.004436
0.7568
Rf
0.813 (7.68)
N;(NC/N),_,
0.9999
0.734 (11.4)
(w - PI,_,
0.9953
R?
- 0.740 (2.61)
c
0.004754
s.e.
k),_ ,
0.504 (4.91)
(n -
- 7.832 (5.88)
c
0.9989
0.542 (5.83)
R:
2.810 (8.30)
(p - WI,_,
Least Squares,
a,
(n - k)I_2
2.4289
D.W.
-0.111 (1.67)
N,.u, - we),_,
- 1.17
L.M.‘t’
0.076 (0.81)
N;(w
L.M.‘t’ - 1.19
0.091 (1.92)
0.146 (1.85)
D.W. 2.2474
s,(Pc-PL,
- 0.59
L.M.‘t’
(k - 0,
D.W. 1.9787
- 0.203 (6.09)
L.M.‘t’ -0.67
D.W. 2.0038
- 0.339 (3.93)
0.171 (4.97)
- 0.201 (3.12)
(p- w)t_2 a,
tests:
Three-Stage
variables and diagnostic
s.e. 0.004998
c
Explanatory
Table A.1 The estimated model. Method of estimation:
Appendix A
0.755
F(4,18)
F(9,8) 3.86
0.457 (3.12)
Atax,
0.792
F(8, 10)
1.246 (3.82)
4,
F(7, 12) 0.768
-0.717 (8.30)
(k - 0,
1961-1984.a
0.426 (2.49)
- 0.253 (1.67)
q-3
-0.179 (2.93)
tax,-3
TIP1
- 0.097 (2.71)
- 0.337 (5.54)
0.323 (7.06)
C”,,(W- w’),_ I
Tf
I,
0.764 (6.38)
(NC/N),
- 0.766 (10.6)
(w-p),
% 2 z? k - 0.123 (2.66)
8
F 2
i c,,Jp - g),_,
:, E.
3
? 8
9
;; f
4 8
? 0 2. g. 3.
Y::
(s - In),
r1
A?%,,
1.020
(8.18)
2.946
0.02552
s.e.
(144.5)
c
0.038734
0.9988
Rf
0.9950
(5.97)
- 3.236
u,
Rf
A.D.F. 2.81
0.5016
- 0.39
L.M.‘t’
C.R.D.W.
(37.4)
0.059
time
2.4068
D.W.
5.897 (4.60)
0.090 (1.15)
0.622
(4.74)
u,
0.07
L.M.‘t’
0.362
1.9245
D.W.
(4.13)
0.8761
(s-m),_*
Rf
(5.15)
0.045
(S-&l
-0.39
L.M.‘t’
(4.49)
- 10.81
4
(s-m),_,
s.e.
C
0.009789
s.e.
0.045 (5.15)
0.201
(1.35)
(b-m),_,
2.3489
D.W.
(6.57)
0.229
APO,,
(3.35)
rt- 1
0.99149
Rf
(23.4)
0.771
AP,,,- I
- 0.088
c
0.04104
s. e.
C
0.856
F(5, 16)
(2.57)
- 0.592
cy* -y*j,
0.178
F(5, 16)
(4.60)
- 1.208
(It-1
0.445
F(8, 10)
(15.9)
- 1.421
(P” - PL
I
0.030 (5.87)
0.030 (5.87)
(P,CPLI
(1.91)
(PO-P),-1
-3.113
0.238
v-2
(6.08)
(P,-P)tml - 0.024 (7.90)
0.137
time
(4.08)
dum
? 3 8. 3.
0.842
0.789
0.895
0.952
0.791
0.917
0.910
0.971
1.006
0.895
1980
1981
1982
1983
1984
3
0.365
0.346
0.322
0.35 1
0.417
0.395
0.256
0.244
0.557
0.820
0.472
0.000
1 2
1.206
1.469
2.093
1.946
1.603
1.276
1.820
2.064
1.242
1.912
1.916
2.133
2.411
1.249
2.425
0.799
1.584
1.831
1.268
2.398
2.127
0.000
2.380
0.000
3
1.809
1.836
1.795
1.716
1.751
1.923
1.912
1.508
1.212
1.646
2.039
0.000
0.000 - 0.563
- 0.347
-0.179
-0.150
-0.109
-0.119
- 0.333
- 0.532
- 0.470
- 0.257
- 0.923
- 0.921
- 0.900
- 0.887
- 0.912
- 0.938
- 0.865
- 0.698
- 0.597
- 0.365
- 0.292 - 0.223
0.000
3
0.000
2
07.57
08.34
13.63
13.14
05.69
04.40
13.89
17.30
07.19
03.42
07.46
06.15
12.82
14.87
06.34
02.26
12.22
18.23
08.37
02.94
13.86
14.48
15.85 14.80
2
1
Pll
- 3.260 - 2.890
- 3.140
11.58 12.20 12.19
-2.820 - 2.960 - 2.940
-2.090 09.52 10.34 10.91
08.51
- 3.310 - 1.970
-2.180 - 4.080
02.68 06.69 08.49 08.32
0.000
1
Y*
00.00
1
s
and the real interest rate; they are in percentage for the remaining variables.
- 0.460
- 0.390
-0.330
- 0.350
- 0.560
- 0.710
- 0.600
- 0.360
- 0.290
- 0.360
- 0.270
1
W-P
a The multipliers are reported in percentage points for the rate of unemployment
0.574
0.857
0.647
0.872
1979
0.450
1978
0.911
1.026
1.261
1.262
1975
0.611
0.692
0.672
1974
1976
0.000
1973
1917
2
1
0.000
Model:
r
k’
? 2
% 2 3 ?!
$ c. 2
3 h 8 : 3 F;.
+S
2
2 2. 3.
U
Dynamic multipliersa
Variable:
?
Table A.2
98
A. Cristini/European
Economic Review 39 (1995) 8.598
References Ashenfelter, 0. and G. Johnson, 1969, Bargaining theory, trade unions and industrial strike activity, American Economic Review 59, 35-49. Beckerman, W. and T. Jenkinson, 1986, What stopped the inflation? Unemployment or commodity prices?, Economic Journal 96. Beenstock, M., 1987a, An aggregate model of output, inflation and interest rate of the industrialized countries, D.P. no. 167 (Centre for Economic Policy Research, London). Beenstock, M., 1987b, The balance of payments of oil-importing developing countries: An aggregate econometric analysis, D.P. no. 165 (Centre for Economic Policy Research, London). Breusch, T. and L. Godfrey, 1981, A review of recent work on testing for autocorrelation in dynamic economic models, in: D. Curry et al., eds., Macroeconomic analysis: Essays in macroeconomics and economics (Groom Helm, London). Cristini, A, 1989, OECD activity and commodity prices, D. Phil. thesis (Oxford University, Oxford). Deaton, A. and G. Laroque, 1990. On the behaviour of commodity prices, Mimeo. (Princeton University, Princeton, NJ). Dornbusch, R., 1986, Dollar, debts and deficits (Leuven University Press, Leuven). Enoch, C. and M. Panic, 1981, Commodity prices in the 7Os, Bank of England Quarterly Bulletin, 42-53. Flesig, H. and S. van Wijnbergen, 198.5, Primary commodity prices, the business cycle and the reai exchange rate of the dollar, D.P. no. 90 (Centre for Economic Policy Research, London) Dec. Gilbert, C., 1989, The impact of the exchange rate and developing country debt on commodity prices, Economic Journal 99. Gilbert, C., 1991, Primary commodity prices and inflation, Oxford Review of Economic Policy 6, no. 4. Gilbert, C. and T. Palaskas, 1989, Modelling expectation formation in primary commodity markets, D.P. no. 192 (Economic Department, Queen Mary College, University of London, London). Grubb, 1985, The revised OECD data set, W.P. no. 781 (Centre for Labour EZconomics, London). Johnson, G. and R. Layard, 1986, The natural rate of unemployment: Explanation and policies in: 0. Ashenfelter and R. Layard, eds., Handbook of labour economics (North-Holland, Amsterdam). Labys, W.C., 1980, Market structure, bargaining power and resource price formation (Heath, Lexington, MA). Layard, R. and S. Nickell, 1986, Unemployment in Britain, Economica, Supplement, 53, S121-S169. Lucas, R., 1976, Econometric policy evaluation: A critique, in: K. Brunner and A. Meltzer, The Phillips curve and the labour market, Carnegie/Rochester Conference Series on Public Policy (North-Holland, Amsterdam) Mayhew, K., 1979, Economists and strikes, Oxford Bulletin of Fxonomics and Statistics 41, l-19. Paldam, M., 1983, Industrial conflicts and economic conditions, European Economic Review 20, 321-256. Paldam, M., 1989, A wage structure theory of inflation, industrial conflicts and trade unions, Scandinavian Economic Journal 1. Paldam, M. and P. Pedersen, 1982, The macr~conomics strike model: A study of seventeen countries, 1948-1975, Industrial and Iabour Relation Review 35, 504-521. Vines, C. and P. Ramanujam, 1988, Commodity prices, financial markets and world income, Mimeo. Winters, A., 1987, Models of primary price indices, Oxford Bulletin of Economics and Statistics 49, no. 3.307-327.
European Economic Review 39 (1995) 83-98
Primary commodity prices and the OECD economic performance Annalisa Cristini * Department
of Economics, University of Bergamo, Piazza Rosate 2, 24100 Bergamo, Italy Institute of Economics and Statistics, Oxford UK
Received September 1992; final version received October 1993
Abstract The relationship linking primary commodity prices to the OECD economic performance is analyzed by explicitly accounting for the presence of a two-way causality. The macroeconomic model is built on a relatively small number of equations which represent the interplay of five markets: primary commodity-, financial-, OECD labour-, OECD and LDC product market. The difference between primary commodity- and manufactured good price formation is emphasized. Quantitative results are provided on the basis of historical estimations and dynamic simulations. Keywords:
Primary commodity prices; Economic performance; OECD
JEL classification:
E17; E24; E31; E44; F4
1. Introduction Since the 1970’s oil shocks, the formation of primary commodity prices, as well as their impact on the economic performance of the industrialized economies, has been the object of many studies; however, the usual approach was to address
* This paper is based on my Oxford D.Phil thesis for which I am most grateful to my supervisor, Steve Nickell. The Institute of Economics and Statistics of Oxford, the Centre for L&our Economics, the London School of Economics, the Italian Ministry of University and Research and Bergamo ‘Unione Industriali’ are acknowledged for financial help. I also wish to thank David Grubb for providing some of the data. The usual caveats apply. 0014-2921/95/$09.50 0 1995 Elsevier Science B.V. All rights reserved SSDI 0014-2921(94)E0124-4
A. Cristini/European
84
Economic Review 39 (1995) 83-98
these two topics separately, thereby disregarding potential feedbacks existing between them. ’ The objective of this paper is precisely that of appraising this overlooked two-way causality using a relatively simple model. The latter builds on two observations; the first one is that the industrialized economies, taken together, basically represent the demand side of the primary commodity market; hence primary commodity prices are endogenous in a model which takes the industrialized countries as a single block. The second observation arises from the difference existing between the bahaviour of primary commodity prices and that of manufactured good prices; such a difference is explicitly accounted for by specifying two separate mechanisms of price formation. The layout of the paper is the following. The theoretical model is outlined in the next section, while its working is described in Section 3. Sections 4 and 5 report estimation results and simulation exercises. Conclusions are drawn in the final section.
2. The model
The model (Cristini, 1989) views the OECD as a unified block which interacts with the rest of the world via the primary commodity market and the capital market. Since all intra-block trades are purged by construction, the block’s imported inflation is fully accounted for by the variations of the average import price or the average primary commodity price index as long as the latter is a good approximation of the former. ’
2.1. The economy of the OECD block
The which product and on 1
economy of the OECD block builds on the Layard-Nickel1 (1986) model has been successfully applied to several OECD economies. The OECD market is assumed to be imperfectly competitive; firms forecast demand this basis set employment and output prices. The general form of the price
Beenstock (1987~1, b) is an exception. ’ Cristini (1989) shows that the real import unit value is directly proportional to an aggregated real primary commodity price index as long as: 6) the proportion of imported primary commodities relative to imported manufactured goods is greater than the proportion between the same class of goods in gross output and (ii) these proportions are constant. Although from 1970 to 1985 industrialized countries have increased their self-sufficiency in primary commodities while tending to import a larger percentage of manufactured products from developing countries, the proportionality between the primary commodity price index and the import price index still holds.
A. ~ris~ini/E~ro~an
Economic Rmiew 39 (1995183-98
equation, which is determined by substituting revenue function, is the following: 3
85
expected demand into the marginal
~-w=[FD(~,(p-p~),Cb~,a,(k-1),(w-w”),r).
(I)
The employment equation is obtained by using the marginal revenue condition in the production function, which is in terms of value added and linearly homogeneous in the logarithms: n-k=iW(/&,(
W-P),
(w-w”),
6 r).
(2)
Both equations are fairly standard except for the real interest rate, which is allowed to affect the marginal revenue condition on the assumption that it may influence at least one of the following factors: the cost of working capital; the discount rate and hence those decisions involving a comparison of the firm’s profits at different times; the elasticity of demand and, hence, the profit maximizing mark-up itself. The labour market is characterized by the presence of unions with which firms bargain the wage; 4 the product-wage equation is the standard one obtained by re-arranging the first-order conditions of the Nash maximand: 5
u7 Pt fax, (PO -P),
(Pn 7)).
(3)
In the empirical version of the wage equation, the number of industrial conflicts, normalized to the number of employees, approximates union power. The model behind the conflict function, which augments the representation of the labour market, assumes that conflicts arise whenever the desired real wage turns out to be higher than the actual wage by an amount greater than the flow cost of a strike (Cristini, 1989).
2.2. The world markets The OECD block interacts with world-wide or inter-block markets where financial assets and primary commodities are traded and their prices are set.
3
Unless otherwise specified, all variables are in log. The symbols are defined as follows: p is the GDP deflator, w is nominal wage, y is a potentially cyclical mark-up, a is labour augmenting technical progress, k is capital, 1 is labour force, n is employment, r is level of the real interest rate, Cp are deviations of real demand from potential output which, in turn, is reached when employment equals the labour force; superscript ‘e’ indicates expectations. ’ Other relevant wage-setting mechanisms (market, efficiency wages) can be derived as special cases of the bargaining specification (Johnson and Layard, 1986). ’ In Eq. (3f, UP is union power, p is the replacement ratio, rax are employer and employee taxes, p0 and p, are oil and non-oil commodity prices, respectively.
A. Cristini / European Economic Review 39 (1995) 83-98
86
Unlike manufactured good prices, which are mainly cost-determined, primary commodity prices, since they are usually set in competitive markets (Labys, 19801, are expected to absorb many of the effects induced by variable economic conditions and to be highly and positively responsive to excess demand, at least in the short run. In addition, it has been argued that homogeneity and storability, which characterize such commodities, may make them sufficiently similar to financial assets. 6 To test this hypothesis the rate of interest is also allowed to affect the price of primary commodities via a speculative storage function. Finally, in order to avoid some of the usual estimation problems, the empirical version of the commodity price function 7 is derived from the reduced form of the structural model (Gilbert and Palaskas, 1989): 8
+“8&-l])’
- [ u6rf-1 + '7kl
(4)
Eq. (4) behaves in accordance with an error-correction model; the variables appearing in the curly brackets are expressed in real terms and represent the long-run equilibrium relationship. The real interest rate is set in the financial market as the price which equates demand and supply of loanable funds. The private sector requirement is mainly directed to investment plans whereas the funds collected by the public sector are used to finance outstanding debts. Supply comes from accumulated wealth, e.g. OPEC wealth and savings. Real primary commodity prices may enter the real interest rate equation as long as commodity prices are used as demand indicators and/or there is some substitutability between financial and commodity assets 9: ,-= R(@-P), u,z,
(P,-PL
(S-P>>
(b-p)>
(PO-P)?
Y*)
(f-p), (5)
The representation of the international financial market also includes a function describing LDC external debt, which has been particularly relevant at least since the debt crisis of the early eighties.
6 In particular the equivalence with financial assets depends on the extent to which primary commodities are stored; in this regard, since the occurrence of stock outs is not allowed in linear models, such models tend to yield an excessive degree of assimilability (Deaton and Laroque, 1990). ’ We do not attempt to describe the oil price as it has been highly dependent on OPEC cartel decisions. The oil market regained some competitiveness only from the mid eighties. ’ In Eq. (4) L is the nominal interest rate, L indicates empirically chosen distributed lags and 5 and 5 are demand and supply indicators, 9 In Eq. (5) m is money supply, b is OECD government debt, f is OPEC wealth, y* is LDC GDP and s is LDC external debt.
A. Cristini/European
Economic Review 39 (1995) 83-98
87
The accumulation of debt over time depends both on the real interest rate and on the primary debt; in addition, the present value of the latter determines the level of sustainable debt and thereby adds a long-run solution to the short-run accumulation relationship (Dornbusch, 1986). The non-interest debt component, though affected by domestic policies, has been largely shaped by the developments of the world economy, the relevant indicators of which we take to be the terms of trade vis-a-vis OECD and vis-a-vis oil exporting countries and the rate of OECD unemployment: s-P=S(r,(P,-P),(P”-P,),U,Y*).
(6)
In order to avoid unstable coefficients, which may arise if the debt crisis of the early eighties caused a change of regime, the impact of each explanatory variable is allowed to change between the pre- and the post-default period. 2.3. The developing country block The non-OECD block is represented by an aggregated developing country GDP equation. The latter can be thought of as a reduced form of an IS/LM type system: (7)
3. The working
of the model
The model is composed of Eqs. (11, (21, (31, (41, (5), (61, (7) plus the equation determining the number of industrial conflicts (NC). In addition, the rate of unemployment is linearly linked to the log of employment and labour force by the relationship: U = 1 - n. In the short run wage and price forecasting errors generate nominal inertia which produces a gap between the real wage and the price mark-up over wages. The gap is proportional to the rate of inflation present in the system which in turn must be consistent with the exogenously given level of real demand. Hence, when implemented dynamically, the system solves for W, p, U, pn, r, s, y* and NC while deviations of real demand from potential are taken as given. In the long run, expectations are fulfilled; the price mark-up over wages coincides with the real wage and the system may solve for an additional variable, i.e. the level of demand. In consequence the model solves for (w - p>, U, C#I, (p, - p), r, (s - p), y* and the number of conflicts normalized to the number of employees. The long-run system encloses two fundamental relationships linking commodity prices to the OECD rate of unemployment. One of these relationships underlines the primary commodity market equilibrium, the second one the equilibrium in the Northern economy. In a (p,, -p&U space, the intersection of the two
88
A. Cristini/European
Economic Review 39 (1995) 83-98
ju*
IU
l U
Pn-P ---_.
--__..j w--.._.____
_______.------
_____------
north -A___ , _.___=-=p7<:
Fig. 1. Long-run
________---------.._____
south --..__
equilibrium.
lines determines the equilibrium real price of primary commodities and the equilibrium rate of unemployment (Fig. 1). Notice that the North line is obtained for any given real wage and is described, in the (w -p&U space, by the intersection of the real wage and price equations. lo All points on the North line are points of equilibrium for the North: the rate of inflation is constant and unemployment is a NAIRU. Above and below the North line the rate of inflation is, respectively, increasing and decreasing. Suppose that the North follows an expansionary policy in order to lower the rate of unemployment to U’ below U*. Depending on the relative inertia of wages and prices, real wages will set at some new point between C and D, thereby initiating a positive rate of inflation. In addition, since the expansionary policy creates extra demand for primary commodities, the price of these increases correspondingly up to point B. Such a rise, by moving the wage line rightwards, sharpens inflation, which becomes proportional to the segment ED rather than CD. If the expansion is ‘once and for all’ and money supply is not accommodating, real money balances effects are likely to bring the system back to equilibrium. Alternatively, one may think of preserving the lower rate of unemployment and decreasing inflation by moving the wage line leftwards towards point D. A well-known way to achieve such an objective is by appreciating the OECD currency relative to the LDC currency; however this policy is detrimental for the non-OECD block and likely to involve large balance of payments deficits in the North. If the demand or supply shock is permanent, then the North and, possibly, the South line, depending on the type of shock, may shift permanently and determine a new long-run equilibrium. In this regard it is instructive to point out
lo Alternatively the latter relationship can be obtained from the unemployment the price equation provides the corresponding level of real demand.
equation.
In this case
A. Cristini / European Economic Review 39 (1995) 83-98
that, for any given South line, the flatter the North line is, the more responsive the long-run rate of unemployment to any given shock.
4. The estimated
89
is
model
All equations are estimated simultaneously using Three-Stage Least Squares; the methodological procedure accords with the ‘general to specific’ approach. Nominal variables are all expressed in OECD currency, where this is obtained from the basket of currencies of the countries entering the block; l1 similarly, the interest rate is obtained by weighted average of national interest rates, the weights being the GDP shares. The eight estimated equations are reported in Table 1, Appendix A. 4.1. The OECD product and labour markets The way the model features in its empirical version defines specific links between the various markets which delineate the propagation mechanism. A direct link between the OECD economy and the financial market is revealed by the presence of the real interest rate both in the price equation and in the employment equation. In particular, in response to 1 p.p. rise of the real interest rate, the long-run employment falls by 0.62% while the long-run price mark-up over wages rises by 0.49%, ceteris paribus. On the other hand, the wage behaviour is not directly affected by the real interest rate; instead, as a result of the import price component of the wedge, it joins the OECD economy to the primary commodity market. l2 In particular, wages respond to an overall index of primary commodity prices because a distinction between oil and non-oil prices was not empirically successful 13. Labour and product market interact closely with each other though the real wage responds to the rate of unemployment with a three-year delay; there is, however, an indirect but current effect of the rate of unemployment on wages which works through the conflict equation which, in turn, contributes to
l1 In adopting this type of aggregation, rather than, for example, converting all nominal variables into US dollars, we follow the IMF which is the main source of our data. However specified, currency aggregation may be limiting in so far as the variability of the exchange rates of OECD currencies against the dollar may have distribution effects within the OECD. Similar effects may also be relevant to non-OECD economies. See Cristini (1989) for a detailed description of the variables. I2 In the price equation primary commodity prices, which might have affected the mark-up, turned out to be statistically insignificant (t = 0.6 for pa and t = - 1.6 for p,). I3 The overall primary commodity price index is a time varying weighted average of oil and non-oil prices. Gilbert instead (1991) finds that the consumer price inflation responds more rapidly to oil than to non-oil prices.
90
A. Cristini / European Economic Review 39 (1995) 83-98
determine an overall 2.6% fall of the long-run real wage in response to a 1 p.p. rise in the rate of unemployment. l4 The number of conflicts, which exercise a positive pressure on the real wage, are reduced by persisting unemployment which, by signalling bad market conditions, increases the vulnerability of workers and persuades them to reduce their industrial action; this finding is in line with most of the empirical literature on strikes. l5
As appears from the real interest rate equation, the link between the OECD economic activity and the real interest rate runs both ways as the rate of OECD unemployment depresses the rate of interest; on the other hand the South’s economic activity is apparently irrelevant to the financial market: indeed, as is clear from the estimated LDC GDP regression, the OECD rate of unemployment well summarizes the state of both economies. The real interest rate is directly affected by the primary commodity market; in particular the positive coefficients of both oil and non-oil primary commodity prices are likely to capture restrictive policies in the presence of inflationary pressure. A rise in debt financing relative to money also determines a rise in the real interest rate without a significant difference for the debtor country. The presence of the rate of unemployment in the estimated primary commodity price equation confirms the two-way relationship between OECD demand and primary commodity market; the negative influence of the rate of unemployment is quite pronounced in the short run but relatively small in the long run when a 1% fall of U raises real commodity prices by around 2%. I6 On the other hand, the interest rate has no obvious effect which substantiates the results of other studies (Enoch and Panic, 1981; Winters, 1987; Gilbert and Palaskas, 1989; Vines and Ramanujam, 1988) and suggests that primary commodities are likely to have features which distinguish them from normal financial assets. ” The LDC debt equation does not reveal significant regime changes but turns out to be highly responsive to a deterioration of the North economic performance, given the latter’s level of money supply; debt can fall only if the trend GDP rises
l4 Notice that the significance of the rate of unemployment in the wage equation substantiates the existence of an OECD Phillips curve (see Beckerman and Jenkinson (1986) for a different conclusion using country data). I5 Ashenfeher and Johnson (19691, Mayhew (1978), Paldam (1983,1989), Paldam and Petersen (1982). ” Higher elasticities are obtained by Flesing and Van Wijnbergen (1985) and Enoch and Panic (1981). t7 If L.DC debt is included as an additional regressor, as suggested in Gilbert (1989), the coefficient is unexpectedly positive and the specification fails the parameter-stability test.
A. Cristini/European
12
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Economic Review 39 (1995) 83-98
4
5
6
7
8
9
91
lo
wz
Fig. 2. Estimated long-run equilibrium.
relative to the actual one. l8 The latter is also strongly economy: a 1 p.p. rise of the OECD rate of unemployment 3% of LDC GDP.
linked to the North implies a fall of over
4.3. The estimated long run The empirical North and South lines are derived using the steady-state solutions of the estimated equations. The South line actually reduces to the non-oil primary commodity price equation. The North line is obtained by equating the real wage equation with the price mark-up over wages and then replacing the real interest rate and the number of conflicts using the relevant equations. l9 In order to analyze the role of the international transmission mechanisms, two restricted versions of the complete model (model 1) have also been considered. In one case, the South block, represented by the LDC debt and GDP equation, has been exogenized (model 2); in the other case, both the South block above and the primary commodity market have been excluded (model 3). Fig. 2 illustrates the estimated long-run equilibrium. (i) For the period 1961-1984 the estimated equilibrium rate of unemployment is around 7%. An upsurge of the oil price shifts the North line downwards and the South line upwards: if the oil price doubles the long-run rate of unemployment increases by 0.88 p.p. which implies a 2.85% fall of LDC GDP.
‘* Potential LDC GDP (JJ * ) is defined by the estimated time and time squared. I9 The North line is
values obtained
-0.0293~(p,-p)=1.8573+0.259~a-0.542~(k-I)+1.602~fax-0.058~~* +0.028~(b-m)+0.0339~(p,-p)-3.022~U. where all exogenous
variables
are valued at their sample mean.
by regressing
log(y * ) on
+0.003.rime
92
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Economic Review 39 (1995) 83-98
(ii> The South equilibrium line is invariant to the exclusion of the LDC GDP and LDC debt equations. On the contrary, the North equilibrium line gets steeper. This fall of the North economy responsiveness to changing primary commodity prices is caused by the exclusion of the LDC debt transmission mechanism which, in response to the rise of U following a primary commodity price shock, sets up a positive pressure on the real interest rate and hence an additional rise in the rate of unemployment. This effect dominates the feedback from LDC GDP to the rate of unemployment which, on the contrary, tends to reduce the initial rise of U. This result suggests that the presence of large LDC external debts worsen the negative long-run effects on OECD unemployment (and hence on LDC GDP) caused by oil price hikes or restrictive policies; on the other hand the link between the South GDP and the North economic activity appears to be beneficial for both blocks when hit by bad shocks. (iii) When both the South block and the primary commodity market are excluded, the overall equilibrium reduces to the equilibrium of the North, i.e. a vertical line in the ( pn -p)-U space which can be more interestingly described by the intersection of the price and the wage equations in the (w -p&U space, as in the small open economy case. In line with the literature which emphasizes normal cost pricing procedures, the price line is here flatter than the wage line.
5. Simulations In order to characterize the short-run dynamics of the model, a few simulations are performed 20. The assumption is that we are always in the short run, hence deviations of demand from trend are exogenous while wage and price forecasting errors are present and endogenous. The impact of exogenous shocks on each endogenous variable is measured in terms of the endogenous variable’s deviations from its historical dynamic simulation. Simulations are performed on the last twelve years of the sample and assume a twofold rise of the oil price (see Cristini (1989) for simulations concerning other exogenous variables). The effects of the shock are analyzed for the three different models introduced in Section 4.3: these successive restrictions allow an assessment of how relevant international linkages are in the short run relevance and how they work. The dynamic multipliers of the main endogenous variables are reported in Table 2, Appendix A. 20
In the context of comparative simulations, the Lucas critique (Lucas, 1976) is very relevant. It applies either/both when the reduction process from the Data Generation Process to the statistical model incorrectly conditions on variables which are not weakly exogenous or/and when expectations are mistakenly assumed to be backward-looking though they really are forward-looking. The estimation procedure we have adopted goes some way towards assuring the correctness of the model-reduction process as well as the validity of the expectations assumption. Proper superexogeneity tests would require long computations in view of the number of variables involved in the model.
A. Cristini / European Economic Review 39 (1995) 83-98
93
As far as the rate of unemployment is concerned, the three multipliers show a similar path: they all reach a maximum two years after the shock, then fall and tend to the long-run value quite fast. If the South block is excluded the multiplier decreases, in accordance with the long-run analysis. However, it is the presence of the non-oil primary commodity market which contributes most to rising the rate of unemployment above the initial direct upsurge, implying that the impulses from p, to the wage resistance and r are indeed strong. In model 3 the final rise of U is less than half that implied by model 1; likewise the maximum peak is 0.82 p.p. rather than 1.26 p.p. The real interest rate responds faster than U to the shock: according to model 3, the real interest rate is 2 p.p. higher than its initial value one year after the shock, it falls thereafter and then reaches a stable 1.8 p.p. rise. The inclusion of the primary commodity market increases the variability of the real interest rate multiplier which actually reflects the oscillations that non-oil primary commodity prices undergo after the oil shock. 21 In this case, the multiplier tends to stabilize at a lower value since the impact of a higher rate of unemployment dominates the impact of higher commodity prices. Finally, by including the South block and hence completing the model, the real interest is pushed up by the LDC debt which itself rises sharply in the first three years and finally reaches + 12%. According to model 3, the real wage falls steadily in the first six years after the shock, then stabilizes at just less than - 1%: the wage-resistance pressure is dominated by the rise of U which at the same time weakens union power and reduces conflicts. If the primary commodity market is included the wage-resistance increases considerably and, even if U increases further, it is strong enough to reduce the real wage fall. If the South block is also included, the wage resistance does not increase, but, because of the financial market impact, U rises further; the real wage then falls again though, on average, by a small amount. Finally, LDC GDP falls initially by 4% and then stabilizes at -3%.
6. Conclusions This paper addressed the analysis and estimation of the relationship linking OECD activity and primary commodity prices. The recognition that the link between North and South runs both ways underpins the theoretical model which views the OECD as a unified block interacting with the South through capital and primary commodity markets. The simulation exercises, performed using the estimated model, show that the quantitative response of the North rate of unemployment to an oil price shock is significantly determined by the behaviour of
” The standard deviation of the real interest rate multiplier is lowered to 2.26 in model 3 with respect to 3.57 and 4.71 in model 1 and 2, respectively.
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A. Cristini/European
Economic Review 39 (1995) 83-98
non-oil primary commodity prices which, being pushed up by the oil hike, fuel both wage resistance and real interest rate. On the assumption of doubling oil prices, the overall rise of U reaches a maximum of 1.26 p.p. two years after the shock and decreases thereafter to around 1 p.p. The response of the real wage is determined by two opposite forces: a positive one, induced by the real wage resistance and a negative one, stemming from the rise in the rate of unemployment; they almost counterbalance and leave the real wage practically unchanged. The real interest rate increases by an average of 2 p.p., a third of which is mainly ascribable to the rise in the LDC debt. Indeed, the South is overall badly hit by the oil shock: its external debt rises above 10% while its internal product declines by 4-3%. Primary commodity prices have also a significant impact on the equilibrium values of the OECD rate of unemployment and LDC GDP. In this respect, it appears that the presence of large LDC external debts increases the vulnerability of both economies to negative shocks, whereas the recognition of the interdependence between OECD and LDC economic performances improves their capacity to face and absorb such shocks.
Notes to table A.l: a t statistics in parentheses, The L.M. test is a modified Lagrange Multiplier to test for a first-order autocorrelation in the presence of a lagged dependent variable and IV. We perform the test by first running two-stage least squares and then regressing the dependent variable on the original explanatory variables plus the first lag of the residuals obtained from the initial regression; the set of instruments used is the same in the two regressions. See Breusch and Godfrey (1981). The Chow test for parameter stability (split 1972) is constructed as follows: (SSR, - SSR, - SSR,)/(SSR, + SSR,).(T -2k)/ k, which is distributed as F(k, T - 2k), where SSR,, SSR,, SSR,, are the residuals sum of squares from the regression on the first T observations, the second (T - T,) observations and the complete set of observations respectively. Instruments include constant, trend, dummy, current and lagged exogenous variables and lagged endogenous variables. All variables are as previously defined except for time= linear time trend and dum = dummy equals 1 in 1976-77.
NC,
(w - p),
(n - k),
(p-w),
Dep. var.
1825.76
s.e.
0.014 (2.16)
N; C
R:
s. e. 0.004436
0.7568
Rf
0.813 (7.68)
N;(NC/N),_,
0.9999
0.734 (11.4)
(w - PI,_,
0.9953
R?
- 0.740 (2.61)
c
0.004754
s.e.
k),_ ,
0.504 (4.91)
(n -
- 7.832 (5.88)
c
0.9989
0.542 (5.83)
R:
2.810 (8.30)
(p - WI,_,
Least Squares,
a,
(n - k)I_2
2.4289
D.W.
-0.111 (1.67)
N,.u, - we),_,
- 1.17
L.M.‘t’
0.076 (0.81)
N;(w
L.M.‘t’ - 1.19
0.091 (1.92)
0.146 (1.85)
D.W. 2.2474
s,(Pc-PL,
- 0.59
L.M.‘t’
(k - 0,
D.W. 1.9787
- 0.203 (6.09)
L.M.‘t’ -0.67
D.W. 2.0038
- 0.339 (3.93)
0.171 (4.97)
- 0.201 (3.12)
(p- w)t_2 a,
tests:
Three-Stage
variables and diagnostic
s.e. 0.004998
c
Explanatory
Table A.1 The estimated model. Method of estimation:
Appendix A
0.755
F(4,18)
F(9,8) 3.86
0.457 (3.12)
Atax,
0.792
F(8, 10)
1.246 (3.82)
4,
F(7, 12) 0.768
-0.717 (8.30)
(k - 0,
1961-1984.a
0.426 (2.49)
- 0.253 (1.67)
q-3
-0.179 (2.93)
tax,-3
TIP1
- 0.097 (2.71)
- 0.337 (5.54)
0.323 (7.06)
C”,,(W- w’),_ I
Tf
I,
0.764 (6.38)
(NC/N),
- 0.766 (10.6)
(w-p),
% 2 z? k - 0.123 (2.66)
8
F 2
i c,,Jp - g),_,
:, E.
3
? 8
9
;; f
4 8
? 0 2. g. 3.
Y::
(s - In),
r1
A?%,,
1.020
(8.18)
2.946
0.02552
s.e.
(144.5)
c
0.038734
0.9988
Rf
0.9950
(5.97)
- 3.236
u,
Rf
A.D.F. 2.81
0.5016
- 0.39
L.M.‘t’
C.R.D.W.
(37.4)
0.059
time
2.4068
D.W.
5.897 (4.60)
0.090 (1.15)
0.622
(4.74)
u,
0.07
L.M.‘t’
0.362
1.9245
D.W.
(4.13)
0.8761
(s-m),_*
Rf
(5.15)
0.045
(S-&l
-0.39
L.M.‘t’
(4.49)
- 10.81
4
(s-m),_,
s.e.
C
0.009789
s.e.
0.045 (5.15)
0.201
(1.35)
(b-m),_,
2.3489
D.W.
(6.57)
0.229
APO,,
(3.35)
rt- 1
0.99149
Rf
(23.4)
0.771
AP,,,- I
- 0.088
c
0.04104
s. e.
C
0.856
F(5, 16)
(2.57)
- 0.592
cy* -y*j,
0.178
F(5, 16)
(4.60)
- 1.208
(It-1
0.445
F(8, 10)
(15.9)
- 1.421
(P” - PL
I
0.030 (5.87)
0.030 (5.87)
(P,CPLI
(1.91)
(PO-P),-1
-3.113
0.238
v-2
(6.08)
(P,-P)tml - 0.024 (7.90)
0.137
time
(4.08)
dum
? 3 8. 3.
0.842
0.789
0.895
0.952
0.791
0.917
0.910
0.971
1.006
0.895
1980
1981
1982
1983
1984
3
0.365
0.346
0.322
0.35 1
0.417
0.395
0.256
0.244
0.557
0.820
0.472
0.000
1 2
1.206
1.469
2.093
1.946
1.603
1.276
1.820
2.064
1.242
1.912
1.916
2.133
2.411
1.249
2.425
0.799
1.584
1.831
1.268
2.398
2.127
0.000
2.380
0.000
3
1.809
1.836
1.795
1.716
1.751
1.923
1.912
1.508
1.212
1.646
2.039
0.000
0.000 - 0.563
- 0.347
-0.179
-0.150
-0.109
-0.119
- 0.333
- 0.532
- 0.470
- 0.257
- 0.923
- 0.921
- 0.900
- 0.887
- 0.912
- 0.938
- 0.865
- 0.698
- 0.597
- 0.365
- 0.292 - 0.223
0.000
3
0.000
2
07.57
08.34
13.63
13.14
05.69
04.40
13.89
17.30
07.19
03.42
07.46
06.15
12.82
14.87
06.34
02.26
12.22
18.23
08.37
02.94
13.86
14.48
15.85 14.80
2
1
Pll
- 3.260 - 2.890
- 3.140
11.58 12.20 12.19
-2.820 - 2.960 - 2.940
-2.090 09.52 10.34 10.91
08.51
- 3.310 - 1.970
-2.180 - 4.080
02.68 06.69 08.49 08.32
0.000
1
Y*
00.00
1
s
and the real interest rate; they are in percentage for the remaining variables.
- 0.460
- 0.390
-0.330
- 0.350
- 0.560
- 0.710
- 0.600
- 0.360
- 0.290
- 0.360
- 0.270
1
W-P
a The multipliers are reported in percentage points for the rate of unemployment
0.574
0.857
0.647
0.872
1979
0.450
1978
0.911
1.026
1.261
1.262
1975
0.611
0.692
0.672
1974
1976
0.000
1973
1917
2
1
0.000
Model:
r
k’
? 2
% 2 3 ?!
$ c. 2
3 h 8 : 3 F;.
+S
2
2 2. 3.
U
Dynamic multipliersa
Variable:
?
Table A.2
98
A. Cristini/European
Economic Review 39 (1995) 8.598
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