Comment on "Dangers for Ireland of an E M U
without the UK: Some Calibration Results"
by F r a n k B a r r y
J O H N FITZ GERALD
The Economic and Social Research
Institute
I
n the October 1997 issue of t h i s j o u r n a l B a r r y set out a simple model of
t h e I r i s h economy. The model was designed to q u a n t i f y the possible
effects on I r e l a n d of s t e r l i n g weakness, where I r e l a n d is a member of the
E M U and t h e U K remains outside. I n c a l i b r a t i n g t h i s model B a r r y made
extensive use of a range of research on t h e supply side of the economy
u n d e r t a k e n over the past decade i n the E S R I . W i t h i n his model he examined
t h e possible effects on t h e economy of E M U membership where wages are
slower to adjust to exchange rate shocks i n a d o w n w a r d direction t h a n i n an
u p w a r d direction. As he points out i n his article, i n a period of low i n f l a t i o n
t h i s possibility, i f realised, w o u l d increase the cost of a major fall i n sterling.
Barry's model is designed to measure the cost of the likely slow adjustment
of domestic prices and wages to an external shock to the value of sterling. He
uses the results presented i n Baker, Fitz Gerald and Honohan, 1996, on the
speed of adjustment of prices to exchange rate shocks, a n d he considers the
effects on the adjustment process for wages of v a r y i n g these results. W h i l e
Baker et al., found no evidence of Barry's hypothesised asymmetric response
of wages to price shocks, such a response cannot be r u l e d out i n the f u t u r e
and, as a result, the analysis is potentially interesting.
However, B a r r y ' s conclusions are faulty for three m a i n reasons: he uses
t h e w r o n g figures f r o m t h e cited research to e s t i m a t e t h e response of
employment to a shock i n real wages; he uses too h i g h a w e i g h t on G e r m a n
prices i n d e t e r m i n i n g I r i s h consumer prices; a n d he o v e r s i m p l i f i e s t h e
conversion of the estimated cost of a specific shock i n t o the option value of an
independent exchange rate.
F i r s t , i n u s i n g the results from previous research to calibrate his model he
assumes t h a t e m p l o y m e n t and o u t p u t fully adjust to any competitiveness
shock w i t h i n one year; he has t a k e n an a la carte approach to choosing
i n d i v i d u a l coefficients from a series of different models. I n doing so he is, by
i m p l i c a t i o n , imposing restrictions on the relevant models used to estimate the
coefficients, restrictions w h i c h were rejected by the data i n e s t i m a t i o n .
1
T h e research f i n d i n g s on t h e response of e m p l o y m e n t a n d o u t p u t to
changes i n factor prices, w h i c h B a r r y used, were derived from models where
f i r m s ' decisions on i n v e s t m e n t a n d f u t u r e o u t p u t capacity are f o r w a r d
l o o k i n g ; t h e y form expectations about the future behaviour of wages and
prices and, because of the h i g h costs of adjustment, they move t h e i r capital
stock slowly t o w a r d s t h e i r l o n g - t e r m objective. Successive studies of the
behaviour of the tradable sector of the economy have found t h a t models w h i c h
assume f o r w a r d l o o k i n g behaviour by f i r m s provide the best f i t to t h e
available data (Bradley and Fitz Gerald, 1988, and Bradley, Fitz Gerald and
Kearney, 1993). Specifically, Bradley, F i t z Gerald and Kearney, 1993, t r i e d a
model where capital adjusted instantaneously w i t h o u t success, whereas the
model w h i c h assumed a slow response of the capital stock to shocks provided
a satisfactory f i t of the data. A s i m i l a r approach was t a k e n i n Bradley, F i t z
G e r a l d a n d Kearney, 1991, i n e s t i m a t i n g the elasticities for the services
sector, w h i c h are also used by Barry.
I n m o d e l l i n g t h e t r a d a b l e sector the research, on w h i c h B a r r y relies,
assumed t h a t firms formed t h e i r expectations about future prices u s i n g an
a d a p t i v e process. T h e model of factor demands was estimated u s i n g a
t e m p o r a r y e q u i l i b r i u m f o r m u l a t i o n ; i n the short r u n firms cannot vary t h e i r
c a p i t a l stock or productive capacity b u t can v a r y t h e i r use of other i n p u t s ,
i n c l u d i n g e m p l o y m e n t . T h i s approach allowed the e s t i m a t i o n of b o t h the
s h o r t - r u n and the l o n g - r u n elasticity of demand for labour and output i n the
tradable sector. The model results showed a zero short-run own elasticity for
l a b o u r i n t h e t r a d a b l e sector a n d a l o n g - r u n net ( o u t p u t v a r i a b l e ) o w n
elasticity o f - 1 , as used by B a r r y i n his calibration. The results also indicated
t h a t f i r m s closed a r o u n d 10 per cent of the gap between t h e i r desired and
t h e i r actual productive capacity (through investment or disinvestment) each
year.
The logic behind such behaviour by firms is t h a t they know t h a t PPP holds
i n the long r u n and shocks to the real exchange rate, unless there are special
reasons for b e l i e v i n g t h e m to be permanent, w i l l t e n d to be discounted.
1.
Bradley, Fitz Gerald and Kearney, 1993, footnote 13.
Because wages and prices, albeit adjusting slowly, w i l l adjust m u c h more
r a p i d l y t h a n f i r m s can adjust t h e i r c a p i t a l stock a n d t h e i r p r o d u c t i v e
capacity, the effects of w h i c h are seen to be essentially t e m p o r a r y shocks to
the r e a l exchange rate may be small. U n d e r such circumstances i t w o u l d be
more appropriate to use the "short-run elasticities of demand" from Bradley,
F i t z Gerald and Kearney (1993) r a t h e r t h a n the l o n g - r u n elasticities, w h i c h
t a k e a t least 10 years to w o r k themselves o u t . F o r t h e t r a d i t i o n a l
m a n u f a c t u r i n g sector, w h i c h is most dependent on the U K m a r k e t , the shortr u n elasticity o f demand for labour is not significantly different from zero.
However, i f some f i r m s are already o p e r a t i n g at a loss a n d are only
c o n t i n u i n g to operate because the cost of the capital stock is fully discounted,
a shock could b r i n g about t h e i r early demise (early scrapping of the c a p i t a l
stock). A l t e r n a t i v e l y , i f the shock is large enough, f i r m s , w h i l e b e l i e v i n g
themselves to be p o t e n t i a l l y profitable i n the long r u n , m a y be unable or
u n w i l l i n g to finance a period of losses w h i l e wages and prices fully adjust.
These p o s s i b i l i t i e s are recognised on p. 119 of B a k e r , F i t z G e r a l d a n d
Honohan (1996).
I n Baker, F i t z G e r a l d and H o n o h a n (1996), by contrast, f u l l account is
t a k e n of t h e w a y f i r m s form t h e i r expectations a n d of t h e slow speed o f
adjustment of the capital stock.
A second, less serious problem w i t h Barry's c a l i b r a t i o n is the r e l a t i v e l y
h i g h w e i g h t he applies to G e r m a n prices i n his equation for I r i s h consumer
prices. The results i n Baker, F i t z Gerald and H o n o h a n (1996) suggest t h a t
I r i s h consumer prices are p r i m a r i l y d r i v e n by U K prices and the b i l a t e r a l
exchange rate. As a result, consumer prices i n I r e l a n d are l i k e l y to adjust
more f u l l y to a s t e r l i n g shock t h a n B a r r y suggests, w i t h a consequential
fuller adjustment of wage rates.
The t h i r d problem w i t h Barry's article is his t r a n s i t i o n from c a l i b r a t i n g the
costs of a s t e r l i n g shock to his conclusion about the implications for the Baker
et al. (1996) quantification of the possible costs and benefits of E M U e n t r y for
I r e l a n d . A p p e n d i x 6 of t h a t report sets out a methodology (based on Gerlach
(1995)) for e s t i m a t i n g the value of a n independent exchange rate. T h i s takes
account of t h e fact t h a t shocks are o f t h e i r n a t u r e u n c e r t a i n , b o t h i n
magnitude and i n direction. Even i f B a r r y were r i g h t i n his q u a n t i f i c a t i o n of
t h e costs o f a s t e r l i n g shock, the difference between his estimate and the
B a k e r et al., estimate of the cost of such a shock cannot j u s t be added to
q u a n t i f i c a t i o n o f the costs a n d benefits o f E M U e n t r y . These costs a n d
benefits represent the expected value (or cost) of l o s i n g a n independent
exchange r a t e where the p o t e n t i a l shocks w h i c h face the economy i n the
future are uncertain. Under such circumstances, even i f B a r r y were correct i n
q u a n t i f y i n g the cost of a 20 per cent s t e r l i n g depreciation, he w o u l d s t i l l be
incorrect i n his conclusion "that employment losses could be more t h a n twice
as large as the E S R I study predicts" (Barry, 1997, p. 344).
F i n a l l y , w h i l e Barry's implementation of his model of how I r e l a n d m i g h t be
affected by an a s y m m e t r i c response of wages to exchange rate shocks is
flawed, he is correct to h i g h l i g h t the problems w h i c h such an e v e n t u a l i t y
w o u l d pose. I f such an exchange rate shock were to occur i n the context of a
very low a m b i e n t level of i n f l a t i o n , there m i g h t w e l l be significant adverse
effects on the economy. However, i n the l i g h t of the quantification i n Baker
et al., 1996, i t is clear t h a t i t w o u l d not greatly alter the conclusion that, faced
w i t h E M U , I r i s h entry, even w i t h o u t the U K , is likely to provide a small longt e r m benefit to the I r i s h economy.
REFERENCES
BAKER, T., J. FITZ GERALD, and P. HONOHAN (eds.), 1996. Economic Implications
for Ireland of EMU, Policy Research Series No. 28, Dublin: The Economic and
Social Research Institute.
BARRY, F., 1997. "Dangers for Ireland of an EMU Without the UK: Some Calibration
Results", The Economic and Social Review, Vol. 28, No. 4, pp. 333-350.
BRADLEY, J. and J. FITZ GERALD, 1988. "Industrial Output and Factor Input
Determination i n an Econometric Model of a Small Open Economy", European
Economic Review, Vol. 32, pp. 1227-1241.
BRADLEY, J., J. FITZ GERALD, and I . KEARNEY, 1991. "The Irish Market Services
Sector: An Econometric Investigation", The Economic and Social Review, Vol. 22,
No. 4, pp. 287-310.
BRADLEY, J., J. FITZ GERALD, and I . KEARNEY, 1993. "Modelling Supply i n an
Open Economy", Economic Modelling, Vol. 10, No. 1, January, pp. 11-21.
GERLACH, S., 1995. "Adjustable Pegs vs. Single Currencies: How Valuable is the
Option to Realign?" European Economic Review, Vol. 29, pp. 1155-1170.