Why real exchange rate appreciations reduce unemployment
A new study by Martin Bodenstein (Federal Reserve Board), Gunes Kamber (Reserve Bank of New Zealand) and Christoph Thoenissen (University of Sheffield) examines the effects of commodity price shocks on labour market outcomes.
When the price of commodities (such as oil, iron ore or dairy powder) rises, commodity exporters experience an expansion in macroeconomic activity. On the face of it, this finding is very much in line with conventional wisdom — the value of exported commodities rises and so does national income (GDP).
However, the increase in economic activity is not confined to the commodity-producing sector. Indeed, the empirical evidence suggests that the macroeconomy expands because of a tightening in labour market conditions in the non-commodity producing sector.
The way commodity price shocks are transmitted to the labour market is as follows: An unexpected increase in the price of exported commodities brings about a ‘wealth effect’.
For a given amount of output and employment, aggregate households’ wealth increases. Richer households inevitably consume more. The increase in consumption, for a given amount of output, causes the real exchange rate to appreciate. A real appreciation implies that the relative price of home to foreign-produced goods increases.
Facing a higher relative price for their goods, domestic firms will try and raise output by hiring more workers. To do so, they post more vacancies, which results in a greater number of matches between workers and firms. As the unemployment rate falls and the number of vacancies posted by firms increases, labour market ‘tightness’, defined as the ratio of vacancies to the unemployment rate, rises.
The researchers use these results as a yardstick against which to assess the performance of small-scale open economy macro models with labour market frictions. These models attempt to simulate real world situations where there are search and matching frictions in the labour market — that is finding the right worker for each job takes time.
Comparing the dynamics of such a model to data shows that the popular search and matching friction approach to modelling labour market dynamics in modern macro models describes the data well.
The key contribution of this paper is the careful analysis of the transmission mechanism of commodity price shocks. A particularly interesting finding is the relationship between labour market tightness and real exchange rate movements; an issue that has not been explored in the literature up to now.
The analysis clearly shows that labour market conditions, in the non-commodity producing sector, improve when the real exchange rate appreciates. This finding contrasts with previous results from the Dutch disease literature that says there is a negative impact on an economy when there is a sharp inflow of foreign currency, or a natural resource discovery which causes the currency to appreciate
Instead of calling for a real depreciation when unemployment rises, and therefore enacting a policy of ‘beggar-thy-neighbour’ which has a negative impact on trading partners, policy makers should be calling for a real appreciation, which in effect ‘betters-thy-neighbour’ and improves outcomes for other trading countries.
Further details can be found at:
If you’re interested in contacting the authors of this research then please contact them using econ@sheffield.ac.uk or +44 114 222 5151
