Competitiveness, labor market institutions, and monetary policy

Impact of exchange rates on firms’ competitiveness

One relevant study shows empirically that the impact of exchange rate changes on firms’ market shares and prices increases with higher trade globalization [2]. As foreign firms enter domestic markets, competition increases, making market shares and prices (hence firms’ revenues and margins) more responsive to changes in the exchange rate.

A long-standing literature has also shown that by affecting firms’ marginal labor costs, changes in competitiveness alter firms’ labor demand, which, in turn, impacts the variability of job flows (job creation and destruction, hence employment and unemployment). Consider an increase in the exchange rate (appreciation): this makes exports more expensive relative to imports, hence it reduces the first and increases the second. The fall in exports reduces exporting firms’ profit margins. If firms cannot adjust wages, hence their cost margins, they will instead reduce their demand for workers, hence employment. The larger the increase in the exchange rate is, the larger the drop in employment is. Several studies have shown that variability in exchange rates has a significant impact on the variability of US employment and wages [3], [4]. Another study also empirically documents the link between firms’ openness to trade and employment volatility [5]. Figure 2 presents a flow diagram outlining the general relationships linking exchange rate fluctuations to unemployment.

Employment variability is mainly driven by variability in job flows, namely job creation and destruction. If exchange rate variability affects employment variability, it is also important to establish a link between exchange rates and job flows. Figure 3 confirms the link between fluctuations in exchange rates (hence in firms’ competitiveness) and job flows by looking at US data. The figure plots the patterns of job creation and job destruction against fluctuations in the real exchange rate for the US over the sample period 1994–2014. The strong co-movement between job destruction and the real exchange rate confirms the importance of the link between competitiveness, job flows, and unemployment. Consider, as before, an increase in the exchange rate. This reduces exports, hence firms’ profit margins. As firms need to adjust their cost margins they will partly reduce their demand for workers, hence employment.

As countries exhibit different labor market institutions, and thus different labor market frictions, fluctuations in the exchange rate, hence in firms’ competitiveness, will have different impacts on how firms will adjust labor demand, thereby affecting the elasticity of labor demand. For example, one study documents the impact of labor market institutions on the elasticity of labor demand to trade [6]. Notice that the more a country is open to trade, the more its firms experience the consequences of variability in exchange rates.

In the trade literature, a group of researchers tackled the above question by using a model with exporting firms that can decide to enter and exit foreign markets and that face labor market frictions (in the form of search frictions). They show that different labor market rigidities provide a form of Ricardian competitive advantage, meaning that firms are more competitive, hence more resilient to external shocks, in the presence of lower labor market frictions [7]. As a result, in countries with weaker labor market institutions, increasing openness to trade might increase unemployment. Along similar lines, another study shows that international differences in labor market regulations affect how firms can adjust to shocks [8].

Likewise, it has been shown that labor market institutions matter for the adjustment of wages and job flows to external shocks [9]. The main channel is the one highlighted so far. External shocks or shocks to the exchange rate affect firms’ competitiveness and profit margins. Firms shall, in turn, adjust labor costs, hence labor demand. Using data for a sample of euro area countries, the authors show that wage (as well as inflation) volatility is negatively related to unemployment benefits and union density. This implies two things. First, that in countries with high union density or high unemployment benefits, wages adjust less in response to external shocks. Second, that firms, wishing to reduce their labor costs, will adjust labor demand, hence employment. The authors use a model and rationalize this empirical link in a more specific way, as follows. High unemployment benefits or high workers’ bargaining power (due, for instance, to high union density) compress firms’ profits and increase wages in the long term. In the short term, wages respond less while firms’ profits respond more to external shocks. Hence, in the face of adverse external shocks, firms’ profits fall sharply, wages remain stable and rigid, and firms fire more workers.

The empirical channels highlighted above pose two important questions for monetary policy, which can deal, in the short term, with exchange rate management. First, if changes in the exchange rate have a detrimental impact on the labor market (the more so the weaker its institutions), it is important to know to what extent the monetary policy should target currency fluctuations. Second, if countries belonging to a currency area (a system of credibly fixed exchange rates) exhibit different labor market institutions (hence differential responses to third-country shocks), it is important to know to what extent the common monetary authority should take those asymmetries into account.

When should authorities intervene to smooth exchange rates?

Two considerations are important in establishing whether a country’s monetary authority should smooth exchange rate fluctuations—by changing the interest rate or the money supply—because of their detrimental effect on the labor market. First, the authority should consider if and to what extent exchange rate fluctuations may have beneficial effects. Second, the monetary authority should target exchange rate fluctuations only to the extent that the ensuing labor market fluctuations are inefficient.

With respect to the first issue, it is well established in the traditional theory of exchange rate regimes that, in the presence of price rigidities, flexibility in the exchange rate helps to absorb external shocks, which might otherwise produce large changes in net exports. Consider as before an increase in the exchange rate. If domestic prices are fully flexible, they can adjust to compensate for the changes in the exchange rate so that exports do not change. This effect is known as the “insulating property” of the flexible exchange rate [10]. However, in practice, prices, but also wages, are not fully flexible and, as stated before, labor market frictions can hinder the adjustment of firms’ labor costs. Under those conditions, exchange rate fluctuations induce fluctuations in firms’ profits, and, in turn, in labor demand. The resulting increase in employment variability is detrimental to output growth. To the extent that workers and consumers are risk-averse, variability in output and employment might reduce their welfare. In designing the optimal policy response to external shocks, policymakers must consider the above trade-off and choose an exchange rate response by balancing those two effects.

One recent study tackles this question by examining the optimal exchange rate regime (namely the optimal response of the monetary authority to exchange rate fluctuations) using a model where countries are open to trade and experience labor market frictions in the form of “congestion externalities” [11]. Two main results emerge from the analysis. First, in response to external shocks that change terms of trade across countries, it is optimal for the monetary authority to change interest rates so as to reduce fluctuations in the exchange rate. Furthermore, as external shocks modify exchange rates and exports, hence firms’ labor demand, changing interest rates to reduce variability in the exchange rate will, in turn, help stabilize employment variability. Second, the response to the exchange rate should be larger for countries with stronger labor market frictions (due to weaker labor market institutions). If larger labor market frictions hinder the ability of firms to cope with external shocks, the monetary authority has higher incentives to reduce exchange rate fluctuations.

At this stage, it is important to clarify to what extent labor market institutions might induce inefficient fluctuations in employment. One relevant study shows that unemployment fluctuations are inefficient whenever workers’ bargaining power in negotiations is too large compared to the efficient share of the surplus that workers should receive from production. Under these circumstances, workers extract large wages relative to their contribution in production. This increases firms’ marginal labor costs and can reduce production. Additionally, since workers can extract large wages, too many of them (relative to available vacancies) search for a job. This reduces the likelihood of finding a job and induces a congestion externality into the labor market. In this case, it might be optimal for the monetary authority to reduce the interest rate and increase demand, hence production.

Exchange rate effects within a currency area

As discussed above, when labor market frictions induce inefficient fluctuations in employment/unemployment and when firms change their labor demand in response to external shocks, it is optimal to smooth or fix the exchange rate. This is the choice made by countries that form or choose to belong to a currency area, as this is effectively a means of establishing a stable exchange rate. However, countries belonging to a currency area might still be exposed to other external shocks that change their relative price (even as the nominal exchange rate is fixed). Consider the case of the euro area. All countries are exposed to the same worldwide external shocks. However, since they have different labor market institutions they react differently to the same external shock [9]. Since the European Central Bank decides on a common monetary policy, the question arises as to whether it should take into account those differences across countries and how they affect the various countries’ responses to external shocks.

One study examines this question using a currency area model with different labor market frictions [11]. The authors show that the monetary authority acting optimally and in the interest of all countries (i.e. maximizing the total sum of all member countries’ aggregate utility) should choose the interest rate by taking into consideration the weighted average of the inflation and output gaps of all area members. Furthermore, monetary authorities should assign different weights to the countries depending on the strength of their labor market institutions. In particular, the authors find that the central monetary authority should assign higher weights to countries with higher labor market frictions, as their firms are more vulnerable to external shocks. Stabilizing the labor markets of more vulnerable countries also has positive reverse effects on the other area members. If, in response to external shocks, output falls more in vulnerable countries, their citizens will decrease their consumption demand of goods produced in the rest of the area. If this happens, exports of other area members will fall, with negative repercussions for their firms.

Finally, it should be noted that while a monetary authority can help smooth asymmetries in the transmission of shocks and their spillover effects in the short term, in the long term, it is advisable for a currency area that labor market reforms are implemented to reduce labor market frictions and to make countries’ labor markets more similar. These reforms should include the adoption of individual bargaining agreements as opposed to collective bargaining agreements. Such reforms, by changing the landscape of labor market negotiations, will render wages more flexible and help firms to cope with external shocks.