Exchange Rates, Employment and Labour Market Rigidity

• Author: João Cerejeira,Fernando Alexandre,Pedro Bação,Miguel Portela
• Published date: 01 May 2017
• Date: 01 May 2017
• DOI: http://doi.org/10.1111/twec.12376

Exchange Rates, Employment and Labour

Market Rigidity

Fernando Alexandre

1

, Pedro Bac¸ ~

ao

2

,Jo

~

ao Cerejeira

1

and Miguel Portela

3

1

University of Minho and NIPE, Braga, Portugal,

2

University of Coimbra and GEMF, Coimbra,

Portugal, and

3

University of Minho and NIPE, Braga, Portugal, and IZA, Bonn, Germany

1. INTRODUCTION

THE aim of this study was to investigate the importance of labour market institutions in

the transmission of exchange rate shocks to employment. The impact of exchange rate

shocks on the domestic economy has always been a cause of anxiety, especially as manifested

in political speeches. In the 1970s and in the 1980s, when the industrialised countries were

hit by oil shocks and by the turbulence in exchange rate markets, following the demise of

Bretton Woods, policymakers were vocal about the impact of external shocks on competitive-

ness and employment –see the discussion in Tatom (1995). In the 1990s, exchange rates

became less volatile and, as a result, exchange rate fluctuations caused only moderate and

intermittent concerns. However, globalisation has increased the exposure of open economies

to external shocks. The rampant US trade deficit, the international financial crisis and the

sovereign debt crisis in the Euro area have revived concerns about exchange rate volatility, its

effects on global trade, the need for international policy coordination and the use of the

exchange rate as an economic policy instrument.

Nevertheless, there is growing awareness of the fact that the impact of shocks depends on

institutions. In an important contribution to this theme, Blanchard and Wolfers (2000) identify

two key facts about European unemployment: the rise since the 1960s and the different evolu-

tion across countries. According to Blanchard and Wolfers, the rise in European unemploy-

ment is the outcome of three shocks: a decline in productivity growth, the evolution of the

real exchange rate and adverse shifts in labour demand. However, these shocks have different

effects in unemployment across European countries. Blanchard and Wolfers relate this hetero-

geneity to the design of labour market institutions in each country and to their evolution over

time. These authors argue that it is the interaction between the shocks and the institutions that

is important to account for the two key facts of European unemployment. We follow this

approach in this atudy and apply it to the study of the reaction of employment to exchange

rate shocks.

Although labour market institutions have been cited as possible additional influences, pre-

vious studies on the impact of exchange rate movements on employment –reviewed in Sec-

tion 2 –have emphasised the role of openness to trade in the evaluation of that impact. The

contribution of this paper is to provide econometric evidence on the role of labour market

institutions in the determination of the impact of the exchange rates on employment. We carry

out our analysis at the sector level, focusing on 22 manufacturing sectors across 23 OECD

countries in the period 1988–2006. To this end, we computed sector-specific real exchange

The authors are grateful for the comments received from the Editor and two anonymous referees, Nico-

las Berman, participants at the conference ‘Increasing labour market flexibility –boon or bane?’, held at

IAB in Nuremberg, participants at the 4th meeting of the Portuguese Economic Journal and participants

at GEMF and NIPE seminars.

©2015 John Wiley & Sons Ltd 993

The World Economy (2017)

doi: 10.1111/twec.12376

The World Economy

rate indexes for each country. The evolution of labour market institutions is capture d by the

OECD’s EPL index. Our results lead us to the conclusion that labour market institutions do

mediate the impact of exchange rates; however, they are more important in the case of low-

technology sectors.

The remainder of the study is organised as follows. In Section 2, we briefly survey the lit-

erature on the channels through which the exchange rate may affect employment. Section 3

presents econometric evidence on the effect of exchange rate changes on employment, in a

panel of OECD countries, and its interaction with openness, technology and labour market

rigidity. Section 4 concludes.

2. MANUFACTURING EMPLOYMENT IN AN OPEN ECONOMY

The reasoning leading from exchange rate movements to employment fluctuations is usu-

ally presented in a very simple way: an appreciation of the national currency, in the absence

of compensating changes in domestic and/or foreign prices, will lead to domestically produced

goods becoming more expensive relatively to foreign produced goods, that is, domestic pro-

ducers will become less competitive. Lower sales and production will then be followed by the

destruction of jobs in domestic companies. However, this ‘import competition’ channel is not

the only possible mechanism linking employment and exchange rate fluctuations. The effect

of exchange rates on domestic employment should be larger in industries that are more open

to foreign competition, not only in the domestic market, but also in foreign markets, that is,

in industries that are more ‘export oriented’. A third channel that has received attention in the

literature works through imported inputs. While the two previous channels are associated with

negative impacts of an exchange rate appreciation on domestic employment, in this third

channel an appreciation of the national currency will benefit domestic companies that rely on

(now cheaper) imported inputs.

Typically, concerns about the working of this mechanism were associated with concerns

regarding the evolution of employment in manufacturing sectors, which were usually viewed

as the tradable sectors par excellence. It is a fact that there have been large changes in manu-

facturing employment. Between 1988 and 2006, manufacturing employment in OECD coun-

tries decreased from around 20 to 15 per cent of total employment, according to the OECD

STAN database. Nevertheless, trends in manufacturing employment have been very diverse

across countries and sectors. The decrease in manufacturing employment was more pro-

nounced in the US and in the UK, where it decreased, respectively, from 15.5 to 10.1 per cent

and from 18.8 to 10.4 per cent. On the other hand, manufacturing employment in countries

like Italy and Germany decreased only slightly, remaining close to 20 per cent of total

employment in 2007. When one looks at the evolution of manufacturing employment by tech-

nology level, using the OECD technology level classification, the conclusion is that low-tech-

nology sectors have been the most affected by the downward trend in manufacturing

employment: their share in total manufacturing employment declined from 46.3 per cent in

1988 to 39.7 per cent in 2006.

Can these fluctuations in manufacturing employment be linked to exchange rate move-

ments? Several studies have reported empirical evidence in favour of this hypothesis. One of

the first to do so was the paper by Branson and Love (1988). Using US data from 1970 to

1986, Branson and Love regress, separately for each manufacturing sector, the log of employ-

ment on the real exchange rate and variables that control for other sources of change in

demand. Branson and Love then use their estimates to compute the effect of the US dollar

©2015 John Wiley & Sons Ltd

994 F. ALEXANDRE, P. BAC

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AO, J. CEREJEIRA AND M. PORTELA