Wage Formation, Unemployment and Business Cycle in Latvia

This paper integrates the alternating-offer wage bargaining (AOB) in a fully-fledged New Keynesian open economy model, and estimates it to the Latvian data. Further on, the paper studies the model's properties and compares them to alternative specifications for labour market modelling, i.e. the Nash wage bargaining with both Taylor-type wage rigidity and without exogenously imposed wage inertia, a reduced-form sharing rule, and a reduced-form wage rule. The goal of the paper is to choose a labour market modelling specification that suits best the needs of the central bank of Latvia in terms of macroeconomic modelling and forecasting. The results indicate that the AOB model suits the Latvian labour market well. The paper concludes with a simulation of economic effects from a permanent increase in the minimum-to-average wage ratio, as observed in Latvia, and finds potentially large losses of employment and output.