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Cyclical Wage Movements in Emerging Markets Compared to Developed Economies: the Role of Interest Rates

  • Nan Li

    (the Ohio State University)

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This paper documents that, at the aggregate level, (i) real wages are positively correlated with output and, on average, lag output by about one quarter in emerging markets, while there are no systematic patterns in developed economies, (ii) real wage volatility (relative to output volatility) is about twice as high in emerging markets compared with developed economies, and (iii) real wage volatility, as a ratio of output volatility, decreases with the level of financial development across countries. I then present a model of contractual arrangements between workers and employers in a small open economy that helps explain this contrast. Only employers have access to financial and capital markets in the model, but they need to borrow working capital to pay for labor costs before production is carried out. The idea is that countercyclical interest rates and less developed financial markets in emerging markets make it less optimal for employers to provide workers with relatively stable wages, leading to more volatile and procyclical wages. More specifically, the total wage bill is procyclical when the financial cost of hiring labor is countercyclical. The intertemporal substitution effect of countercyclical interest rates on labor input offsets the direct effect of productivity movements, resulting in less responsive employment. Therefore, the wage is exposed to more volatility and displays more procyclicality. This is further demonstrated by calibrating the model using data from Mexico and Canada.

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Paper provided by Society for Economic Dynamics in its series 2008 Meeting Papers with number 438.

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Date of creation: 2008
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Handle: RePEc:red:sed008:438
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