DRAFT
FOR STAFF 'SE ONLY
TARIFFS, EMPLOYMENT AND THE CURRENT ACCOUNT: REAL WAGE
RESISTANCE AND THE MACROECONOMICS OF PROTECTIONISM
S. van Wijnbergen
CPD Discussion Paper No. 1985-37
August 1985
CPD Discussion Papers report on work in progress and are circulated
for Bank staff use to stimulate discussion and comment. The views
and interpretations are those of the authors.
Abstract
Using a standard complete specialization model of a small open
economy within a rigorous intertemporal optimization framework with contract-
based wage rigidity, we show that permanent tariffs lead to a current account
deterioration and a fall in employment, contradicting most of the literature
on macro-economic effects of import tariffs. The crucial factor in this
complete reversal of standard results is the impact of tariffs on domestic
real product wages via wage indexation. Temporary tariffs will have less of a
negative impact on the CA or potentially even a positive impact, because they
increase the consumption rate of interest (the terms at which future
consumption can be traded for current consumption) and so increase private
savings.
Extensions towards incorporating a more general production structure,
investment and the use of tariff revenues to provide wage subsidies are
presented.
I. Introduction
The continued persistence of the post 1973 slowdown in world-wide
economic growth has led to increasing pressure in many countries to maintain
growth while preserving external balance by using commercial policy to protect
domestic production. Much of the existing literature on macro-economic
effects of tariffs seems to lend support to that view (at least under a fixed
exchange rate.regime). For a recent exposition, see Dornbusch (1980) or
Chalciolades (1981) who provide fur .her references going all the way back to
Metzler (1949). See furthermore, Johnson (1958), Mussa (1974a) or Boyer
(1977). The argument is straightforward: higher tariffs (with revenues
rebated to consumers) have a pure substitution effect leading to a higher
demand for domestic goods which in turn leads to higher output, income and
therefore savings. Higher savings imply a current account improvement. Under
flexible exchange rates an appreciating currency may offset these effects (see
Mundell (1961), Boyer (1977).
I will argue here however that implausible assumptions on wage
behavior are crucial to those results. Output will only go up if the increase
in tariffs succeeds in lowering the real product wage. Since the macro-
economic literature on tariffs usually assumed fixed nominal wages when
discussing employment effects, the results follow automatically if the tariff
increase succeeds in shifting domestic demand towards our goods.
One problem with all this has to do with foreign retaliation.
Another problem arises because of the issue of real wage resistance. Often
real wage indexation is at the root of internal/external balance conflicts.
It is not clear why commercial policy would succeed in lowering the real wage
-2-
where other attempts have failed. It then becomes of interest to explore the
consequences Gf commercial policy when wage indexation is effective. I will
focus on tariffs in this paper.
A further problem with the macroeconomic literature on tariff policy
is that its conclusions on CA effects are based on models incorporating
arbitrary static savings functions, not a very meaningful procedure in an
analysis of a clearly intertemporal issue such as current account behavior.
An elegant exception is the note by Razin and Svensson (1982) who however
assume market clearing real wages and, in another departure from the standard
Mundell framework, exogenous terms of trade.
In what follows we will stick to the Mundell framework but introduce
contract based real wage rigidity and savings behavior derived from explicit
forward looking maximizing behavior. Section 2 sets a benchmark by analyzing
the full employment case in a two-period framework (the minimum needed to get
a time structure in). I analyze both temporary and permanent tariff
changes. Section 3 introduces contract-based real (consumption) wage rigidity
in response to unanticipated shocks. No second period shocks unanticipated at
the beginning of period two will be considered, so that period will be
characterized by full employment. In Section 4, I briefly discuss to what
extent the results depend on the special assumptions made. More in particular
introduction of aggregate investment and extension to incomplete
specialization are discussed. Section 5 discusses the possibility of using
some or all of the tariff revenues for wage subsidies to get around the wage
rigidity problem. Section 6 concludes.
-3-
2. Tariffs and the CA under full employment
Consider a two country Mundell-Fleming framework where each country
produces only one good. Since in this section factors of production are
always fully utilized output is at its full employment level.
For simplicity we assume utility U to be weakly homothetically
separable in consumption today and consumption tomorrow while the period by
period subutility indices are homothetic and identical in terms of functional
form and parameter values (the arguments may of course differ across
periods). This allows us to define unit utility expenditure functions
1 and 12 which can be interpreted as aggregate price indices, and an
1 2
expenditure function:
E = E( 1)1[2,U) (1)
where 6=1/(1+r ), one over one plus the world interest rate. By choice of
normalization foreign prices are set equal to one. p1 indicates the relative
price of domestic goods in terms of foreign goods in period i (the terms of
trade). Under the assumptions made so far, H i = i, (pl) with
al /ap. = C./Z. with C. consumption of domestic goods by domestic residents
i 1 1 1 1
in period i and Zi real consumption expenditure in period i. By property of
expenditure functions Z. a= E/fl8. so that C = 3E/3p..
1 1 i 1
If we define a similar expenditure function for foreigners and
indicate it by E*, we can write the domestic goods market clearing condition
in each period as:
-4-
X = E + E(la)
1 -p1 p1
X = + (1b)
2 p2 2 (b
where E = 3E/311,, and Xi is output of "our" good in period i. If there '
are tariffs on foreign goods in period i, f= i( i i where
fl = 1+t one plus the tariff rate.
The budget constraint facing domestic residents is:
pX1 +p 2 X2 + tE 1 + 6t2 E 2= E(1 1(p,1+t) 2 2(p,1+t2),U) (2)
Similarly for foreigners:
X1 2 = E (i S 2, U)
where we assumed no trade interventions in the foreign country (-i= 0).
Stars indicate foreign variables. Tariff revenues are redistributed, hence
the terms t E land 6t 2E 2 in the private budget constraint in the home
country.
We will make one important simplifying assumption: we will assume
that the relative price of foreign goods tomorrow in terms of foreign goods
today (6) , is fixed, allowing Hicks-aggregation of current and future foreign
goods. The mqrket clearing equation for that Hicks-aggregate good is
redundant because of Walras' law. A true two-country model would of course
endogenize 6 (or, equivalently, the world rate of interest), leading to two
separate market clearing equations for foreign goods, one for period one and
-5-
the other for period two, only one of which would be redundant. The benefits
of extra generality that endogenizing 6 would yield do not seem to justify
the additional complexity it would also lead to, at least for the particular
issue we are looking at now.
Differentiation of (2) around the zero tariff equilibrium indicates
that
dU = E ((X -E )dp + (X -E ) 6dp2) (2a)
U 1 p 1 2 p2
= E (E* dp1 + E 6dp2)
p1 2
Similarly for foreign welfare:
dU= E (-E dp - E Fdp2
u pl 1 p2
If this is substituted into (1) simple algebra gives expressions for
the terms of trade effects dpi caused by changes in tariffs. For the first
period, terms of trade changes induced by tariffs today and tariffs in the
second period are:
dpI
p1 -1-
df 1 22 pf 1 12 p2f 1
and (3)
dp1
=p - A EE - E E )>O0
df2 22 p1 f2 12 p f2
E.. represents the world substitution matrix plus income effects of terms of
trade changes:
* E * * 2 +22
2 = E + E + E (C1- ), = E + E 2~+ E~ (CE-C2E)
-6-
etcetera. CiE= EP U/EU, the marginal propensity to spend on domestic goods
in period i. We will make the usual assumption that own substitution effects
dominate income effects (Z11+ Z12< 0). The particular structure of the
utility function guarantees that cross-terms such as E etc. are all
positive. A is the Jacobian of (1) after substituting in (2a) and is
positive in stable configurations. Similar expressions can be derived for
dp2 dp2
and-.
df df2
The results are fairly straightforward, higher tariffs today
(dfl > 0) and higher tariffs tomorrow (df2 > 0) will both put upward
pressure on today's terms of trade. The Metzler paradox corresponds to
dp1/dfl > 1, a possibility that cannot be excluded, although we will assume
in the next section that foreign demand elasticities are high enough to rule
it out.
Since we have ignored investment so far, current account effects of
tariffs can be derived by looking at private savings. To avoid uninteresting
ambiguities we will make a symmetry assumption on flow variables across
periods: corresponding flow variables across periods (say, exports today and
exports tomorrow) are assumed equal per unit of time in both periods before
the changes in tariffs. This of course implies that their actual values may
differ since the periods may correspond to time spans of very different
length.
Due to the utility structure assumed, real expenditure in any given
period is a function of welfare U and the consumption discount factor
p = (the inverse of one plus the consumption rate of interest):
1
Z. = E (1,p,U) (4)
TI li
-7-
The current account - in period 1 then becomes
CA1 1 + t E 1 1E 1 (5)
Consider first the effects of a temporary tariff in period 1:
CA1 CA p 1 + CAa ( a)
af +f 1 (Sa)
1 1 p=p 1 2 -f ap af
* 1P * ~ 2 dp
-E (1-C ) - -E C 3 - E df
p1 E af p 2 IE af 1 1 2 ' 1
(A) (B) (C)
Induced income effects in period 1 lead to a CA improvement because part of
the gains will be spent tomorrow (the term above (A)).2/ On the other hand
induced income effects tomorrow have the opposite effect (the term above
(B)). Under the symmetry assumptions made (A) will dominate (B) if
dp1 dp2
d > d . This will be the case if foreign goods today (against which
1 1
the tariff is levied) are a closer substitute for domestic goods today than
1/ Since there is no initial debt, there are no first period interest
payments, so the trade balance and the CA are identical in period 1.
2/ CIE = E 1U/EU , the marginal propensity to spend in period 1. Under the
symmetry assumptions made, CIE/CIIE T1/T2 where Ti is the number of
years in period i. Similarly, Epl/E = T1/T2
-8-
they are for domestic goods tomorrow, a reasonable assumption which we will
make:
fE f E
E E
pl P2
dpl dp2
If that is so, (C) also becomes unambiguously positive: if df df2
1 1
1+fl dp dp2 dp1
p df -D df f F < 0 (6)
1 1 1
where D is the expenditure share of domestic goods and F of foreign
goods. (6) indicates that high but temporary tariffs (only in period 1) will
decrease the discount factor (increase the consumption rate of interest) since
they lead to a real appreciation in period 1 that will be partially reversed
later on (i.e. an anticipated depreciation over time after the initial
unanticipated appreciation). L/ So temporary tariff increases in period 1
will lead to a current account improvement both because of the favorable
income effects of tariff induced terms of trade changes (the gains of which
will be spread out over both periods) and because they lead to an increase in
the consumption rate of interest favorably affecting private savings. It
should be stressed that the CA improvement stems from the fact that the tariff
is temporary.
An expression similar to (5) can be derived for future temporary
tariff increases (df2 > 0). It is straightforward to show that with the
1/ For an extensive discussion of the relation between the real exchange
rate, the consumption rate of interest and the current account cf Martin
and Selowsky (1983) or Dornbusch (1983).
-9-
assumptions made so far future tariff increases will lead to a period 1
current account deficit. The story is similar: income effects via favorable
terms of trade changes come in the future but are partially spent today, and
the real consumption rate of interest falls.
Taking the two results together to analyze a permanent increase in
tariffs dfl = df = df, we get the result that a permanent tariff leaves the
current account unaffected:
dCA * dpl * dp2
d f E1 (1-C I) E 2C E (7)
d P1 IEd 2 IEd1 12 df
dCA dCA dCA
(Note that df - df + d df2 etc.)
1 2
Under the symmetry assumptions made the discount factor will not change
dp dp2 dp1 2 1 (8)
df D df df F = 0 (8)
while income effects are the same in both periods. Accordingly a permanent
tariff increase has no impact on the current account, independent of the type
of elasticity conditions that are usually claimed to be sufficient to
guarantee such an improvement (c.f. Dornbusch (1980)).
The reason for this is quite straightforward: a tariff changes
relative prices within the period in which it is levied, but a permanent
tariff does that both today and tomorrow, leaving the relative price of
consumption today in terms of consumption tomorrow (one plus the consumption
rate of interest) unaffected. Accordingly, savings .will not change, which
- 10 -
explains the absence of a current account impact. The extension to endogenous
investment is discussed in Section 4.
All these results are considerably modified however if real wage
resistance to the tariff induced increase in the cost of living is
introduced. That is the subject of the next section.
3. Real wage indexation and macro-economic effects of tariff changes
Wage indexation is introduced in a simple manner: wage contracts are
negotiated at the beginning of each period, incorporating all information
available at that time. They are set at a level that will lead to full
employment if no unanticipated shocks occur during the contract period, and
are indexed on the CPI (1) Since we will not consider any shocks or policy
changes in the second period that are unanticipated at the beginning of that
second period, full employment will obtain in that period. Accordingly the
goods market clearing equation for period 2 remains
X =E + E (9)
2 p2 p2
Of course first period disequilibrium will influence the second period goods
market equilibrium via the intertemporal budget constraint.
In the first period CPI indexation of wages gives us
dw dp1 1
w *Dp + (1-*D) 1+f1
1 1
We will for simplicity set the initial tariff at zero. The period one wage
equation can be rearranged to give an expression for Zhe real product wage in
- 11 -
terms of domestic goods:
dw _dpl =- 1-D (df dpl) (10)
w pl 1 p1
(10) indicates that, in this Mundell-Fleming context, tariffs will push up the
real (domestic) product wage if the Metzler paradox does not obtain, i.e. if
the tariff inclusive price of the foreign good indeed goes up in terms of the
domestic good. We will assume that foreign demand elasticities are high
enough to rule out the Metzler paradox.
Now that first period wages do not necessarily clear the labor
market, period I output is not necessarily at its full employment level.
Capital in period 1 is inherited from the past, there are no intermediate
inputs, so output is a function of the real product wage only:
X = X/ 1
or, differentiating, (11)
dX d(w/pi)
1 1
with s > 0. Replacing (1a) by (10) and (11) gives the new model
incorporating wage indexation.
One result is immediate: if the Metzler paradox does not obtain,
higher tariffs will lead to real wage pressure in the domestic goods sector.
Equ. 10 says that nominal wage changes equal a weighted average of tariff
changes and domestic price changes, ruling out the Metzler paradjx implies
dfl dpl
that > - so the real (domestic) product wage goes up, and employment
1+fI p1
- 12 -
goes down (equ..(11)). Tariff increases would lower the real wage "ex ante",
real wage indexation will, to prevent that, lead to an increase in the real
domestic product wage and therefore to unemployment (qualifications to that
result due to relaxing the Mundell-Fleming complete specialization assumption
are discussed in the next section).
As one might expect, the cut back in aggregate supply because of the
tariff induced real wage pressure will lead to more upward pressure on the
first period relative price of domestic goode than obtains without wage
indexation (WI refers to the wage indexation case, NWI refers to the no wage
indexation case):
dpl dp1 Al+d A1 d
(A-A )> 0 (12)
df If 1 NWI A+d A ( A- 1) )
dpl
if Al < A (i.e. no Metzler paradox or d- < 1); d is positive, see the
df1
appendix for precise expressions. Showing that the same result holds for
permanent tariffs is straightforward.
The impact woge indexation has on the second period terms of trade
response to tariffs is less clear cut: on the one hand higher first period
terms of trade will lead to more substitution towards tomorrow's goods, on the
other hand the cut in first period income and employment leads to a reduction
in demand for all goods, inclusive tomorrow's domestic good. Accordingly,
indicating permanent tariff change by df,
dp2 dp2 >
< 0
WI NWI
with similar ambiguities obtaining with respect to temporary first period
tariffs.
- 13 -
Ignoring second round effects of real wage changes on the.terms of
trade and via that on the consumption rate of initerest and thus on saving
gives
dCA dCA1 dw/p 1
+ p X (13)
df df 1 1w df
WI NWI 1
Clearly the second term is negative pointing to the possibility of a
negative current account response to permanent tariffs under real wage
indexation, since dCAI= 0. Second round effects however will lead to
df
a higher p1 response than obtains without wage indexation, therefore
increasing the terms of trade gains in period 1 and decreasing the discount
al2
factor - (increasing the consumption rate of interest). Both these
1I
effects will improve the CA, so, although the possibility of a negative CA
response is now there, it does not follow unambiguously . A substantially
stronger result can be obtained if we look at the limiting case of a small
country (fixed terms of trade exclusive of tariffs in both periods). Then'the
only CA impact of a permanent increase in tariffs will come via the fall in
income induced by real wage pressure:
* *
p1E 1 1 2pE 2P2 dCA1 dw/pl
* E* I 1w df (14)
1 2 WI
P 1w pl (J11D) < 0
or a permanent increase in tariffs in a completely specialized price taker
will unambiguously lead to a fall in unemployment and a current account
deficit under CPI wage indexation.
1/ X1w 1
- 14 -
For a temporary tariff there is the offsetting effect of the direct
impact of the first period tariff on the real discount factor; but we can
still show that even if a CA surplus results it will be smaller than without
real wage indexation:
i Epipi dCA1 (
E PNWI
P X1w(1-%) + f1E[ 1 > 0
(-) (+)
1
< 1 E 1 2
(+)
dCAl
df1
1f NWI
4. Some Qualifications
We will briefly discuss the consequences of relaxing the complete
specialization assumption and of introducing investment.
Incomplete specialization plays no role in Section 2: all the
conclusions will carry through although one expects smaller relative price
movements since these now also trigger resource shifts. Section 3, with wage
indexation, needs more qualifications. If both capital and labour are mobile
between sectors, Stolper-Samuelson tells us that market clearing wages will
fall or rise in terms of both goods (and therefore in terms of the consumption
price index T1) depending on whether the tariff is levied on the capital or
labour intensive good. Real wage indexation will lead to results similar to
those obtained in Section 3 if the tariff is levied on the capital intensive
- 15 -
good since the indexation scheme will prevent the downward adjustment in real
wages necessary to maintain full employment.
The conditions under which unemployment will arise in response to
tariffs in a Ricardo-Viner sector-specific capital, mobile labor model with
real wage indexation are more complicated and will also involve consumption
A
shares. Consider the small country case (pl= 0). We can use the results in
Mussa (1974b) to derive the condition under which a full employment
equilibrium would be characterized by a lower real consumpion wage after the
imposition of an import tariff:
w - lbD1 f1 w ff
= (n - 4f)fl
wi th f = f/ f + 'DC
1-0 16 18
lGf lf 1 OD
where X. is the fraction of the labor force employed in sector i, a, is
the factor substitution elasticity in sector i and e. is the labor share
:1
in sector i. So the results of Section 3 would also come out in the Ricardo-
Viner context if n < *f. This is more likely if the import competing sector
employed only a small fraction of the labor force (Xf small) or if that
sector has a comparatively low labor demand elasticity because of either
relatively low factor substitutability (af/aD small) or because of a
relatively high capital share ((1-Gf)/(l-E6D) large).
Consider now investment, while reverting to our Mundell-Fleming
context of complete specialization. The natural approach complementing our
optimizing savings behavior is to derive investment from a similar optimizing
procedure:
- 16 -
max Sp2 X2 (L,K1+1 1 1 1 (16)
Ii
is the reproduction cost of capital, a weighted average of p1 and
(1+fl) with weight y on p1 .If we define Q as the value of future output
produced with capital in terms of the cost of capital goods:
6P2
2 (17)
solving (16) gives us
82X X
ax2 ax2
dl1 2 X ) dQ (18)
aK
= hdQ, h>0
or investment will go up or down depending on which way Q moves in response to
the tariff. Now
dg dp2 dpl
S- (1-y) df
Q p2 2 1
dp2 dp1 dp
2 ----+ (1 -y) ( - df1)
For permanent tariffs under the symmetry assumptions made throughout,
dp2 dpl
- - = - for a given level of investment in the absence of wage indexation;
p2 p1
the impact effect will therefore be negative if the Metzler paradox does not
dpl
obtain (- - df < 0).
P1 1
This indicates that in the Mundell-Fleming model for the case of
normal tariff incidence (no Metzler paradox), investment will fall in response
to permanent tariffs, leading to a current account surplus. Second round
- 17 -
effects will lead to a smaller terms of trade improvement today as long as
y > 0 because investment related demand for domestic goods goes down, but to
a larger improvement tomorrow because the cut in investment reduces aggregate
supply tomorrow. The net effect is smaller favourable income effects today,
bigger ones tomorrow and an increase in the real discount factor (decrease in
consumption rate of interest), all of which lead to a deterioration of the CA:
2 2
dCA1 * +2 2/BK dp1 dp2
__ = ((1-C )E + H E p }-{----- }_
df NWI IE p1 1 1T2 D X2/3K df df
(+) ()(-)
2 2
(II)
(19) omits a variety of price level multiplicands by setting them equal to one
via choice of normalization. (II) is the positive impact effect of higher
tariffs on the CA via their negative impact on investment (which in turn is
affected because of the higher cost of capital), but the terms under (I)
collect all the second round effects working in the opposite direction. Once
again going to the small country case allows unambiguous results:
PiEp p, dCA 32 2/3K2
E * + => df 3x 2/3K (1-y) > 0 (20)
Pi
or permanent tariffs will improve the CA contrary to the no-investment case,
but will do so because investment declines.
Incomplete specialization will make this result conditional on the
tariff being levied on the labor intensive good.
- 18 -
5. Wage Subsidies Financed by Tariff Revenues
At the root of the problems discussed in Section 3 is the fact that
real wage indexation leads to an increase in the real domestic-product wage
after an increase in tariffs. A natural response is to use the tariff
revenues to drive a wedge between real product wages and real consumption
wages via wage subsidies: this would allow the real consumption wage to
remain constant without an increase in the real product wage.
In what follows we take a slightly different approach: part of the
tariff revenues is used to keep the utility of wage earners constant.
A related analysis can be found in Dixit and Norman (1980); there however one
of the two factors of production receives all tariff revenues, while we give
wage earners only as much as is needed to keep their utility constant.
Consider a simplified one period version of the model of Section 2.
We now have to distinguish the incomes accruing to the two factors of
production in the home economy. Denote the expenditure function of domestic
wage earners as e and of capitalists as e . Similarly u and u
represent utility of wage earners and capitalists respectively. Accordingly,
tariff revenues equal T = t(e f+ e f). A fraction X of T is handed out
to wage earners. X is determined endogenously in such a way that u will
not be affected by the change in tariffs.
The budget constraint of workers is:
e(p,f,u) = w + At(ef + e f). (21a)
1/ This approach was suggested by Avinash Dixit.
- 19 -
Similarly, capitalists face the constraint
e(pf, pX - w + (1-X) t(e + ef). (21b)
The foreign budget constraint is
E (p,l,U ) X (21c)
Finally goods market clearing implies
e + e + E X
p p p
X will be set in such a way that u = u, allowing the real product wage
W = w/p to remain at its full employment levelL/. Clearly, domestic output
will not be affected under this set up. Simple differentiation of 21a,b,c*
around the zero tariff equilibrium yields:
e udu = (w-e )dp + (X f-(1-X)ef)df (21d)
e du = (X-w-e )dp + ((1-X)e - Xe )df (21e)
u p f f
So an increase in tariffs is good because you get reimbursed for outlays you
did not make (Xef for wage earners and (i-X)ef for capitalists) and bad
because you are only incompletely reimbursed for costs you do incur
1/ Keep in mind we are once again in the complete specialization framework.
- 20 -
(-(l-X)ef for wage earners and -X for capitalists) --
(21d) tells us that wage earners utility will not be affected by the
tariff (du/df = 0) if they receive a share of tariff revenues equal to:
e (1-SP)
(22a)
e + ef
where = i - . The Metzler effect corresponds to a > 1. Accordingly
f p df C
in the case of normal tariff incidence a positive share smaller than one will
suffice to maintain workers utility at the pre-tariff level.
What will happen to capitalists welfare? We can define X as the
wage earners share that would keep capitalists' utility constant:
p
A e f+ eE
(22b)
e + ef
Clearly u is decreasing in X (since X is the wage earners share);
also X > X from (22a,b). Therefore if X is set at X , capitalists,
welfare will always increase (as long as ei> 0; see below).
Another way of seeing this is by assigning equal weight to welfare
gains and looking at national income (in terms of foreign goods) for any
choice of X (and therefore also for X ):
du ~ du dp
e u-+e = (X-e -e ) d + (Xe f-(1-X)ef+(1-X)e f-e f)
= E* dp (23)
p df
1/ In deriving 21d,e we also used homogeneity properties of e and e.
- 21 -
* du
which of course is a familiar result. Since X is set to make e = 0
u df
(23) immediately gives us the expression for capitalists' welfare:
* du dp
X = X => e -= E* -- (24)
u df p df
This establishes my claim that capitalists' welfare will always increase as
long as ep> 0
f
So using part of the tariff revenues to finance wage subsidies does
provide a way around the problems of Section 3. Extension to two periods is
straightforward and will show a positive CA response. Before jumping to
conclusions however, a cautionary note is in order. Affecting the current
account calls for intervention to change the terms of trade between goods
today and goods tomorrow (the real interest rate). Achieving this end by also
introducing within period relative price distortions such as a temporary
tariff is clearly suboptimal under the assumption made.
6. Conclusions
The main purpose of this paper is to show that the traditional analysis of
current account and employment effects of tariffs in the "open economy model"
literature is very sensitive to arbitrary assumptions habitually made about
wage and savings behavior. Section 2 analysed the current account response to
temporary and permanent tariffs under labour market clearing and savings
behavior derived from intertemporal optimization rather than arbitrary
consumption functions; section 3 replaced the labour market clearing condition
by a contract theory type real wage indexation rule, maintaining the
- 22 -
optimizing approach to savings. We kept the structure of the Mundell-Fleming
model traditionally used in macro-oriented discussions of tariffs to
facilitate comparison with that literature.
In the case of labour market clearing real wages a permanent increase
in tariffs is shown to leave the current account unaffected under reasonable
symmetry assumptions, since the income effects caused by tariffs induced terms
of trade changes are the same (per unit of time) in both periods and the
consumption rate of interest does not change. A temporary tariff increase
totoday" however leads to s stronger term of trade induced income effect today
than tomorrow; moreover, the current period apreciation caused by a temporary
tariff is larger than the second period terms of trade improvement, leading to
an increase in the consumption rate of interest. Both factors lead to a CA
improvement as a consequence of temporary first period tariffs.
Real wage indexation is shown to potentially modify these results.
In the Mundell-Fleming context of complete specialization, tariffs are shown
to increase the domestic real product wage if wages are indexed on the CPI.
This in turn implies that an increase in tariffs, if unanticipated at the time
first period wage contracts were concluded, will inevitably lead to
unemployment via the resulting upward pressure on the real domestic product
wage. This holds for both temporary and permanent increases in tariffs. As a
consequence first period output and therefore income declines, contributing a
negative element to the current account response. In the limiting case of an
infinite foreign demand elasticity (small country assumption) this negative
element is shown to dominate: in that case a permanent increase in tariffs
will lead to more unemployment, a fall in first period real output and a
current account deficit.
- 23 -
Temporary first period increases in tariffs will under real wage
indexation also lead to more unemployment and less first period -real output,
but the increase in the real consumption rate of interest they also cause may
(or may not) offset the negative effect on the current account of the fall in
first period income associated with the increase in unemployment. Even if the
CA response is positive it will always be less than the corresponding CA
response to temporary tariffs without real wage indexation.
- 24 -
References:
Boyer, R.S. (1977), "Commercial Policy under Alternative Exchange Rate
R6gimes", The Canadian Journal of Economics, May 1977.
Chalciolades (1978), International Monetary Theory and Policy, McGrawhill, New
York.
Dornbusch, R. (1980). Open Economy Macro-economics, Basic Books, New York
Johnson, H. (1958), "Towards a general Approach to the Balance of Payments,"
Journal of Political Economy.
Martin, R. and M. Selowsky (1983), "Energy Prices, Substitution and Optimal
Borrowing in the Short Run," forthcoming, Journal of Development
Economics.
Mundell, R. (1961), "Flexible Exchange Rates and Employment Policy," the
Canadian Journal of Economics.
Mussa, M. (1974a), "A Monetary Approach to Balance of Payment Analysis,"
Journal of Money, Credit and Banking.
(1974b), "Tariffs and the distribution of income: the Importance
of Factor Specificity, substitutability and intensity in the Short and
Long Run," Journal of Political Economy.
Razin, A. and L. Svensson (1983), "An asymmetry between Import and Export
Taxes," Economic Letters.
-25-
Appendix: Tariff induced terms of trade changes with and
without wage indexation
1. No wage indexation
Differentiating (la,b) after substituting in the budget constraint
(2) gives:
11 12 dpl - E 1 1 dfl - E 1 2 df2
21 X22 dp2 - E 2 1 dfl - E 2 2 df2
where i is defined on page 5.
Applying Cramer's rule immdiately yields
dpl I 1
1 NWI
with AlI = E P2 f1 12- E if1 1 22 > 0
A = 11 22 - X21 12 > 0
A1 , A are the symbols used on p.12.
26 -
2. Wage indexation
Replacing (la) by (10) and (11) yields
X1+ (1-ClE) (1-l) --X dp -(E - (1-C E)(l-*)Z- X )df -E df
1IEPl1 1 pl11 p1 1w 1 pl 2 2
1W- C2 W X (1-*) ) dp -(E + C 2 -X (1-*))df -E df
Pi P2 -I (1 P2 2
21w2E pl 1w 22 2 p2r1 G2E p1 1w -4)d1- d22f
Once again applying Cramer's rule gives
dpI 1+ d
1 W
S=(1-*) - - X ( (- )+ C).
p 1w( 22 (1-C1E) + 12 C2E)
Xi1 < 0 ; 1-C lE= C2E + Cf + C > C 2E; finally the stability condition
11 l22 - 21) 12 > 0 coupled with the symmetry conditions imply that
X22(l-Cl) + 12 C2E< 0 ; putting all that together establishes d > 0
as claimed in the text.