Tsukuba Economics Working Papers
No. 2011-001

Exchange Rate Regimes, Trade, and the Wage ComovementsbyYoshinori Kurokawa, Jiaren Pang, and Yao Tang
April 2011
This Version: August 2011

UNIVERSITY OF TSUKUBA
Department of Economics
1-1-1 Tennodai
Tsukuba, Ibaraki 305-8571
JAPAN

Exchange Rate Regimes, Trade, and the Wage Comovements∗
Yoshinori Kurokawa†, Jiaren Pang‡, and Yao Tang§
August 11, 2011

Abstract
The introduction of exchange rate regimes into the standard Ricardian model oftrade implies stronger positive nominal wage comovements between trading countries
that ﬁx their bilateral exchange rates. Panel regression results based on data from
OECD countries from 1973 to 2010 suggest that countries in the European Monetary
Union (EMU) experienced stronger positive wage comovements with their main trade
partners. In comparison, the positive wage comovements between countries engaged
in non-currency-union pegs were weaker. When we restrict the regression to thesubsample of the EMU countries, we ﬁnd a signiﬁcant increase in wage comovements
after these countries joined the EMU in 1999 compared to the pre-euro era.
JEL classiﬁcation: F1, F3
Keywords: ﬁxed exchange rate regime, currency union, trade, wage comovements∗

The authors are grateful for suggestions and comments from Kozo Kiyota, Steve Matusz, Michihiro
Ohyama, Ke Pang, Yoshimasa Shirai, Chetan Subramanian, Hylke Vandenbussche, and participants at the
Spring 2011 Midwest International Economics Meetings. All errors are ours.
†
Department of Economics, University of Tsukuba, 1-1-1 Tennodai, Tsukuba, Ibaraki 305-8571, Japan.
E-mail: kurokawa@dpipe.tsukuba.ac.jp.
‡
Department of Finance, School of Economics and Management, Tsinghua University, Beijing 100084,
China. E-mail: pangjr@sem.tsinghua.edu.cn.
§
Corresponding author. Department of Economics, Bowdoin College, 9700 College Station, Brunswick,
Maine 04011-8497, USA. E-mail: ytang@bowdoin.edu.

11Introduction

The standard Ricardian model of trade is a real model and thus does not explicitly deal
with the monetary aspects of trade such as changes in nominal prices and exchange rate.
However, as pointed out by Dornbusch, Fischer and Samuelson (1977) and Ito and Ohyama(1985), it is possible to extend the discussion of the standard Ricardian model to deal withthe monetary aspects of trade.
The introduction of a nominal exchange rate to the standard Ricardian model generates an interesting theoretical prediction regarding exchange rate regimes, trade, andcomovements of nominal wages.1 The modiﬁed Ricardian model predicts that if a country
ﬁxes the exchange rate with its main trade partner, then its wage will comove strongly andpositively with its partner’s wage to preserve the relative prices in trade and maintain thesame trading equilibrium. However, if a country ﬂoats the exchange rate, then its wage
does not necessarily comove with that of its main trade partner, as the exchange rate
can adjust to maintain the relative wages and prices. Thus the model predicts stronger
comovements of wages between countries that ﬁx their bilateral exchange rates.
In practice, many countries adopt ﬁxed exchange rate regimes, with the extreme
case being a currency union. In the 1990s, among the 91 economies studied by Sterne(1999), the number of countries adopting an explicit exchange rate target increased from30 to 47. In 1999, the creation of the European Monetary Union (EMU) locked in 11
European countries committed to a single currency, and the EMU has been expanding
since. However, in the wake of recent crises in peripheral countries in the EMU, economic commentators (for instance, Economist (2010)) suggest that relative to Germany,
countries such as Greece and Ireland have wages that are too high for their products tobe competitive internationally. Yet, as EMU members, they do not have the option ofdevaluation to promote their products. Such observations suggest that for countries in
1

Our interests are in the comovements of nominal wages, so in the following discussion the word
“wage(s)” refers to nominal wage(s), unless otherwise noted.

2

a currency union and countries adopting currency pegs, whether their wages align withthose of their main trade partners has important economic consequences.
To the best of our knowledge, however, no previous studies have empirically tested
the prediction of the modiﬁed Ricardian model that ﬁxed exchange rate regimes enhance
the positive eﬀects of trade on wage comovements between countries. This paper now ﬁlls
this void by testing if wages comove strongly and positively between countries that peg
their currencies. The results of panel regressions based on data from 24 OECD countries
from 1973 to 2010 suggest that if a country and its main trade partner were in the EMU,
then their wages experienced stronger comovements, especially in the longer term. However, for countries engaged in non-currency-union pegs, the positive wage comovements
were weaker.
In addition, we run regressions with the sample restricted to EMU countries todetermine whether joining the EMU in 1999 was associated with stronger positive wage
comovements. We ﬁnd that for EMU countries, there was a signiﬁcant increase in wage
comovements after joining the EMU, compared to the pre-euro era.
Many previous studies analyze the comovements of wages with other variables, suchas output, prices, and (un)employment. Surprisingly, however, there are few studies thatanalyze the comovements of wages. In fact, as far as we are aware, there are only threestudies on the subject.
The ﬁrst, Budd, Konings and Slaughter (2002), highlights the comovements of wages
within a multinational. They show the existence of comovements of wages within a multinational ﬁrm through internal risk sharing. The second, Robertson (2000), highlights thecomovements of wages between the interior and border regions in a country. He provides
evidence for these comovements between the interior and border regions of Mexico, thus
indicating that the wage impact of emigration is transmitted to the overall Mexican economy. The third, Lamo, Perez and Schuknecht (2008), highlights the comovements of wages

3

across sectors within a country. They show strong positive comovements of public andprivate sector wages over business cycles since the 1960s in the euro area and a number ofother OECD countries.2
Our paper thus makes the following contributions to both the trade literature andthe wage literature. First, because in reality countries often use diﬀerent currencies, bothexchange rates and nominal wages are important determinants of the relative prices ofexports to imports. Past trade studies, however, have paid little attention to the monetary
aspects of trade. By incorporating the monetary aspects of trade into the Ricardian modeland then empirically testing the resulting implications, we reveal the diﬀerence in the wageeﬀects of trade under the ﬁxed and ﬂoating exchange rate regimes.
Second, we highlight that for countries engaged extensively in trade, the choice of aﬁxed exchange rate regime will enhance wage comovements between countries. Our results
add to the knowledge of wage comovements, as previous work has focused on inter- andintra-country wage comovements due to internal risk sharing within a multinational ﬁrm
and emigration.
Third, our results add to the knowledge of how an exchange rate peg acts as anominal anchor. A currency peg or membership of a monetary union is one way toprovide a nominal anchor for a country’s output prices or inﬂation rate (Edwards, 1993;
Calvo and Vegh, 1994; Willett, 1998). Our results suggest that in addition to providing
a nominal anchor for output prices or the inﬂation rate, a monetary union can provide anominal anchor for wages.
The rest of this paper is organized as follows. In Section 2, we incorporate a nominal
exchange rate into the standard Ricardian model and then derive an empirical question
from the model. We document the regression speciﬁcation and data in Section 3. Section
2

Lamo et al. (2008) also study causal linkages between public and private sector wages, i.e. the public/private wage leadership. Their causality analysis suggests that although inﬂuences from the private
sector appear on the whole to be stronger, there are direct and indirect feedback eﬀects from public wage
setting in a number of countries as well. See the references in their paper for studies on wage leadershipin a particular country (mainly Sweden plus a few others).

44 reports regression results. We oﬀer a discussion of the results in Section 5 and conclude
in Section 6.

2

TheoryIn this section, we incorporate a nominal exchange rate into the standard Ricardian modelof trade and thus address the monetary aspects of trade. We then set up an empiricalquestion regarding exchange rate regimes, trade, and wages that is theoretically meaningful.
Consider the standard Ricardian model. There are two countries: home and foreign.
There are two goods: good 1 and good 2. There is one input factor, labor, and the laborendowment is given in each country. The markets are perfectly competitive, and thetechnology exhibits constant returns to scale.
Suppose that the home country has a comparative advantage in good 1 and thatthe foreign country has a comparative advantage in good 2. If these two countries start
trading with each other, then the home country will produce and export good 1, and theforeign country will produce and export good 2. Because the output price must equal theunit cost under perfect competition, the following zero-proﬁt conditions must hold:𝑃1 = 𝑎1 𝑊,(1)

𝑒𝑃2∗ = 𝑒𝑎∗2 𝑊 ∗ ,(2)where 𝑃1 and 𝑃2∗ denote prices of good 1 in the home country and good 2 in the foreigncountry, respectively; 𝑎1 and 𝑎∗2 denote unit labor requirements for good 1 in the homecountry and good 2 in the foreign country, respectively; and 𝑊 and 𝑊 ∗ denote wages in
the home country and in the foreign country, respectively. The variable 𝑒 is the exchange
rate, deﬁned as the price of the foreign currency in terms of the home currency.
In this trading equilibrium, relative prices 𝑃1 /(𝑒𝑃2∗ ) are determined between the5slopes of the home and foreign production possibility frontiers (PPFs):
𝑃1
𝑎∗1
𝑎1
<
<
.
𝑎2
𝑒𝑃2∗
𝑎∗2

(3)

𝑎∗2
𝑊
𝑎∗1
<
<
.
𝑎2
𝑒𝑊 ∗
𝑎1

(4)

Equations (1) to (3) imply

Equation (4) indicates that in this trading equilibrium, the corresponding relative wages
𝑊/(𝑒𝑊 ∗ ) must be greater than the foreign/home unit-labor-requirement ratio for good
2 but less than that for good 1. This relationship between relative prices 𝑃1 /(𝑒𝑃2∗ ) andrelative wages 𝑊/(𝑒𝑊 ∗ ) is illustrated in Figure 1. Note that we need to also consider
demand conditions to determine the exact equilibrium relative prices and wages on theline 𝐴𝐵. However, since the speciﬁc levels of equilibrium relative prices and wages are
not crucial for the following discussion, we do not specify demand conditions and simply
assume that the equilibrium relative prices and wages locate at some point on the line
𝐴𝐵.
Relative
prices𝐵𝑎∗1 /𝑎∗2
𝑃1 /(𝑒𝑃2∗ )𝑎1 /𝑎2𝐴𝑎∗2 /𝑎2

𝑊/(𝑒𝑊 ∗ )𝑎∗1 /𝑎1

Figure 1: Relative Prices and Relative Wages

6

Relativewages

Equation (4) can be rewritten as
𝑎2 𝑊
𝑎1 𝑊
<𝑒< ∗ ∗
∗
∗
𝑎1 𝑊
𝑎2 𝑊

(5)

which indicates that in this trading equilibrium, the corresponding exchange rate 𝑒 must
be greater than the home/foreign unit-cost ratio for good 1 but less than that for good 2.
The Ricardian model is a real model, so trade is determined by real variables, suchas relative prices and wages, and is not aﬀected by changes in nominal variables, suchas nominal prices and wages. Depending on the exchange rate regime, however, changes
in nominal variables have diﬀerent implications regarding the comovements of wages. To
clarify the role of exchange rate regimes, we now analyze the ﬁxed and ﬂoating exchange
rate regimes separately.
Suppose that the foreign wage 𝑊 ∗ increases under the ﬁxed exchange rate regime. To
maintain the initial trading equilibrium, the home wage 𝑊 has to increase proportionallywith the foreign wage 𝑊 ∗ , leaving the relative wages 𝑊/(𝑒𝑊 ∗ ) and relative prices 𝑃1 /(𝑒𝑃2∗ )constant. Thus wages in the home and foreign countries would comove strongly andpositively in the case of the ﬁxed exchange rate regime.
Suppose that, on the other hand, the foreign wage 𝑊 ∗ increases under the ﬂoatingexchange rate regime. If the increase in the foreign wage 𝑊 ∗ is completely negated by thechange in the exchange rate 𝑒 in the other direction, then the relative wages 𝑊/(𝑒𝑊 ∗ ) andrelative prices 𝑃1 /(𝑒𝑃2∗ ) would remain unchanged. No change in the home 𝑊 is required
to maintain the initial trading equilibrium. Hence, there is a possibility that under theﬂoating exchange regime, the home wage does not comove with the foreign wage.
The same arguments also hold when inﬂation occurs in either country. It can beshown that if the foreign price 𝑃2∗ or the home price 𝑃1 increases under the ﬁxed exchange
rate regime, then the home and foreign wages 𝑊 and 𝑊 ∗ would comove strongly andpositively. On the other hand, if the foreign price 𝑃2∗ or the home price 𝑃1 increases under
the ﬂoating exchange rate regime, then the home and foreign wages 𝑊 and 𝑊 ∗ do not7

necessarily comove due to the ﬂexibility in the exchange rate.
We should note that unit labor requirements–labor productivities–have so far been
assumed to be constant. If these real variables are changed, however, then relative prices
and wages–real variables–will be changed because the slopes of the home and foreign PPFs
will be changed. Thus nominal wages in the home country and the foreign country do
not necessarily comove strongly and positively even under the ﬁxed exchange rate regime.
However, if labor productivities for goods 1 and 2 both increased by the same proportionin each country, then the relative prices and wages would remain unchanged because theslopes of the home and foreign PPFs would remain unchanged. In this scenario, nominal
wages in the home country and foreign country should comove strongly and positively
under the ﬁxed exchange rate regime.3
In this section, we introduce a nominal exchange rate to the standard Ricardianmodel. The model implies that if the exchange rate with a trade partner is ﬁxed, then
the wage in the home country will have stronger positive comovements with the trade
partner. On the other hand, if the exchange rate with the trade partner is ﬂoating, then
the wage in the home country does not necessarily comove with the trade partner due tothe ﬂexibility in the exchange rate.4

3Regression Speciﬁcation and Data

To test empirically whether wages would exhibit stronger positive comovements for countries that peg their currencies, we ﬁrst estimate the following two baseline models with3
If we consider demand conditions and assume that both countries have the same homothetic preferences
over the two consumption goods, it can be shown that equilibrium relative wages do not depend onlabor productivities. In this case, the comovements of wages are not aﬀected by any changes in laborproductivities. In the empirical section, we will include labor productivity in some of the speciﬁcations
but not in others to recognize the uncertain role of labor productivity.
4
Note that the arguments developed here also hold in the framework of the standard Heckscher-Ohlin(H-O) model of trade. By incorporating a nominal exchange rate into the standard H-O model and using
the factor price equalization theorem, we obtain 𝑊 = 𝑒𝑊 ∗ and 𝑅 = 𝑒𝑅∗ , where 𝑅 and 𝑅∗ are the homeand foreign rentals, respectively. Thus it is obvious that under the ﬁxed exchange rate regime, the homeand foreign wages 𝑊 and 𝑊 ∗ would comove strongly and positively.

8

country ﬁxed eﬀects:
Δ𝑙𝑛(𝑊𝑖𝑡 ) =𝛽0 + 𝛽1 Δ𝑙𝑛(𝑊𝑖𝑡∗ )+ 𝛽2 ⋅ 𝑝𝑒𝑔𝑖𝑡 ⋅ Δ𝑙𝑛(𝑊𝑖𝑡∗ ) + 𝛽3 ⋅ 𝑡𝑟𝑒𝑛𝑑 + 𝑢𝑖 + 𝜖𝑖𝑡(6)Δ𝑙𝑛(𝑊𝑖𝑡 ) =𝛾0 + 𝛾1 Δ𝑙𝑛(𝑊𝑖𝑡∗ )+ 𝛾2 ⋅ 𝑛𝑜𝑛 𝐶𝑈 𝑝𝑒𝑔𝑖𝑡 ⋅ Δ𝑙𝑛(𝑊𝑖𝑡∗ )+ 𝛾3 ⋅ 𝐶𝑈𝑖𝑡 ⋅ Δ𝑙𝑛(𝑊𝑖𝑡∗ ) + 𝛾4 ⋅ 𝑡𝑟𝑒𝑛𝑑 + 𝑢𝑖 + 𝜖𝑖𝑡(7)where 𝑊𝑖𝑡 is the wage in country 𝑖 in year 𝑡, and 𝑊𝑖𝑡∗ is the wage in country 𝑖’s base country
in period 𝑡. Because the model generates predictions based on the nominal wages andexchange rates, we use only the nominal wage as the dependent variable. In speciﬁcation
1 (equation (6)), 𝑝𝑒𝑔𝑖𝑡 is a dummy variable that takes the value 1 if country 𝑖’s currency
is pegged to its base country in period 𝑡, and 0 otherwise. In speciﬁcation 2 (equation(7)), we diﬀerentiate between two types of pegs. 𝐶𝑈𝑖𝑡 is a dummy variable indicating thatcountry 𝑖 and its base country are in a currency union in period 𝑡, and 𝑛𝑜𝑛 𝐶𝑈 𝑝𝑒𝑔𝑖𝑡 is adummy variable indicating other types of pegs. The variable 𝑡𝑟𝑒𝑛𝑑 is a linear time trend,
and 𝑢𝑖 is the country ﬁxed eﬀect.
If 𝛽2 , 𝛾2 and 𝛾3 are positive, then the prediction of the modiﬁed Ricardian model thatwages comove positively and strongly under a ﬁxed exchange rate regime is supported.
Because the Ricardian model is a general equilibrium model, we treat both home andforeign wages as endogenous to the model. Hence, in testing whether 𝛽2 , 𝛾2 and 𝛾3 arepositive, we are examining whether there is a positive conditional correlation between
home and foreign wage growth under a ﬁxed exchange rate regime. Our empirical work
does not attempt, and should not be interpreted as, the identiﬁcation of the eﬀect ofexogenous wage changes in the foreign country on the home wage.
Our empirical analysis uses wage data from the Source OECD (www.sourceoecd.org)
which provides detailed wage information of OECD countries starting from 1973. Wage9

is measured by the index for nominal hourly earnings in manufacturing sectors. We madethis choice because the products of the manufacturing sectors are highly tradable.
The classiﬁcation of the exchange rate regime follows Klein and Shambaugh (2006),
who determine whether a country pegs its currency to the base country, based on thevolatility of the exchange rate. In Klein and Shambaugh (2006), country 𝑖’s base country
is the country to which country 𝑖 pegs its exchange rate or the country with which country
𝑖 has the most signiﬁcant trade relationship. We also follow their choice of base countries.5
Because we are looking at OECD countries, the currency union is the EMU. The
countries included in our sample are Australia, Austria, Belgium, Canada, Denmark,Finland, France, Germany, Hungary, Iceland, Italy, Japan, Korea, Luxembourg, Mexico,
Netherlands, New Zealand, Norway, Poland, Portugal, Spain, Sweden, Turkey, and the
UK. The US is not in the sample because the US does not have a dominant trade-partner
to be used as the base country. Our sample covers data from the ﬁrst quarter of 1973 to
the fourth quarter of 2010. The details about the base country, episodes of exchange rate
pegs, and data range for each country are documented in Table 1.
The ﬁxed eﬀects in the speciﬁcations account for the time-constant idiosyncrasy in
the growth in nominal wage, such as country-speciﬁc productivity path or inﬂation in a
speciﬁc country relative to its base country. We also include a linear time trend to capture
the trend in the growth rate of the nominal wages. Such a trend could arise due to the
productivity slowdown since the 1970s and the decline in inﬂation rates in some countries.

4

Empirical Results

4.1

Main Regression Results

We present the estimation results of speciﬁcation 1 (equation (6)) in Table 2. The top row
indicates the frequency at which we calculate the growth rates of the wage in country 𝑖
and its base country. We choose to use the wage growth over a quarter, a year, two years,
5

The description of their data can be found at http://www.dartmouth.edu/˜jshambau/

10and four years. The results in Table 2 suggest that pegs have no signiﬁcant eﬀect on wage
comovements at 5% signiﬁcance level. This seems unsupportive to our hypothesis.
In Table 3, when we follow speciﬁcation 2 (equation (7)) to diﬀerentiate between the
two types of pegs. While the non-currency-union pegs reduce wage comovements at somefrequencies, the EMU always increases wage comovements signiﬁcantly. For instance, atthe quarterly frequency, the coeﬃcients on the interaction between the currency union andwage growth in the base country is 0.64. This result implies that if the wage in country 𝑖’sbase country increases by 1%, being in a currency union with the base country predicts anadditional increase of 0.64% in country 𝑖’s wage. Interestingly, at the two-year frequency,
the coeﬃcient on the interaction is 0.96, which is close to unity.
In addition, as indicated by the coeﬃcient of wage growth in the base country(Δ𝑙𝑛(𝑊𝑡∗ )) in Tables 2 and 3, wages in general do comove positively between a country
and its base country at the quarterly frequency. For instance, the coeﬃcients are 0.27 and0.23 for the quarterly data, which implies that when the wage in country 𝑖’s base country
increases by 1%, the wage in country 𝑖 increases by 0.27% and 0.23%, respectively.
By comparing results for diﬀerent frequencies, we see that the 𝑅2 increases with thelength of the time interval. For instance, in Table 3, the 𝑅2 associated with quarterly wage
growth is 0.22. When we use the growth rate over four years, the 𝑅2 increases to 0.49,
indicating that our simple model appears to have good explanatory power with respect towage growth in the long run.
Although the baseline speciﬁcations (6) and (7) are based on the modiﬁed Ricardianmodel, we recognize that in the framework, there are multiple channels through which thewage in country 𝑖 will comove with its base country. In particular, the labor productivity
growth and CPI inﬂation of a country are two important determinants of nominal wage inthe country. Wage comovements can arise due to a positive correlation in the productivity
growth and inﬂation between two countries. Hence, to diﬀerentiate the diﬀerent channels

11

of wage comovements, we add labor productivity growth and CPI inﬂation of a country to
the regression. The measure for labor productivity is output per worker in the industrial
sectors.6 With these variables included, we ask whether there are still positive wage
comovements not caused by comovements in productivity growth and inﬂation.
The results associated with this modiﬁcation are presented in Table 4 and Table 5.
Comparing Table 4 to Table 2, we now see pegs in general no longer reduce the positive
wage comovements between country pairs. In particular, for wage growth over two years,
pegs in general strengthen the positive wage comovements, although the strengthening
eﬀects are weak statistically. Comparing Table 5 to Table 3, there are two diﬀerences.
First, the interaction between the currency union and wage growth in the base country is
positive and signiﬁcant only when we look at growth over two years. Second, the interaction between non-currency-union pegs and wage growth in the base country no longer hasa negative and signiﬁcant coeﬃcient. The coeﬃcient is actually positive and marginallysigniﬁcant for the wage growth over two years. After controlling for productivity growthand inﬂation, these regression results seem to suggest that the positive eﬀect of currency
pegs on wage comovements appears mainly in the intermediate term over two-year periods.
We will discuss this ﬁnding in more details in Section 5.

4.2

Regression Results Based on EMU Member Countries

In Table 6, we repeat the estimations in Table 5 but restrict the sample to countries
currently in the EMU. More speciﬁcally, the countries included are Austria, Belgium,
Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, andSpain. The time range remains 1973 to 2010. These estimations serve two purposes.
First, we want to explore if non-currency-union pegs worked diﬀerently for countries notin the EMU or for countries that later joined the EMU. Second, the additional regressions
6
The CPI data are obtained from the Source OECD. Labor productivity is computed as the constantprice output in the industry divided by employment in the industry. Both output and employment in theindustry are also obtained from the Source OECD.

12

provide direct evidence of whether joining the EMU is associated with stronger positive
wage comovements.
Relative to Table 5, the results regarding the coeﬃcients on non-currency-union pegs
in Table 6 are very similar. Non-currency-pegs only strengthened the wage comovements
when we focus on the wage growth over two-year intervals. We also run regressions withthe countries not in the EMU and ﬁnd that non-currency-pegs have no strengthening
eﬀect on wage comovements, except that the pegs have marginally positive eﬀects when
the dependent variable is the wage growth over two-years. To preserve space, we do notreport these results in the paper. These regression results indicate that non-currency-pegs
had similar eﬀects on wage comovements for countries in and out of the EMU.
Meanwhile, regarding the coeﬃcients on the EMU dummy-base country wage interaction in Table 6, the signs are all positive. Compared to Table 5, the signiﬁcance levelis higher for wage growth over two-year and four-year intervals. Hence, for the same 11
countries, the positive wage comovements with their base countries after joining the EMU
are stronger than before joining the EMU.

4.3

Robustness Checks

In unreported regressions, we estimate another pair of alternative speciﬁcations by replacing the linear time trend with time ﬁxed eﬀects. The results are similar to Tables 2 and3, but weaker. However, we believe that time ﬁxed eﬀects are not suitable for testing
the theoretical predictions. To see the reason, note that Germany is the reference for almost all countries in the EMU. If our hypothesis is correct, wages in these EMU countries
should comove with German wages in each time period. However, when we include thetime ﬁxed eﬀects, the regressions will attribute such comovements with the German wages
to time-speciﬁc eﬀects, rather than attributing them to the currency union, which is atime-constant fundamental.
Finally, we add the dummy variables for pegs in general, currency union, and non13

currency-union pegs to the regressions that are not reported in this paper. These standalone dummy variables are almost always insigniﬁcant. The insigniﬁcance, consistent withthe model, also makes sense intuitively, as there is no obvious reason why wage growth
rates should be higher or lower in countries that ﬁx their exchange rates.

5

Discussion

In subsection 4.1, we explored the three mechanisms that can lead to comovements inwages. The ﬁrst is the trade-exchange-rate mechanism. Intuitively, for a country tomaintain a stable trade relationship with its base country, its wages must comove positively
with the base country to keep relative prices constant if the exchange rate is ﬁxed. Second,
wages in the two countries can comove positively due to a correlation in the productivity
growth rates. For countries that share close economic relationships, it is conceivable thatnew technologies spread across borders quickly, leading to common growth in productivity.
Third, a positive correlation in inﬂation can also contribute to positive wage comovements.
For instance, hikes in commodity prices typically lead to higher inﬂation in many countries.
The three channels are not mutually exclusive, as the latter two channels can bepresent whether or not two countries trade. If they trade, then according to the model,
an increase in the wage in country 𝑖 due to inﬂation or a productivity gain will lead toa similar rise in the wage in its base country. However, even if the two countries do nottrade, common inﬂation or productivity trends can still cause wage comovements. For
instance, if countries 𝑖 and 𝑗 do not trade but both import oil from a third country, thenan increase in oil prices will lead to inﬂation and growth in the nominal wages in bothcountries 𝑖 and 𝑗. Similarly, if countries 𝑖 and 𝑗 do not trade ﬁnal products but shareideas and technologies, then their wages can both rise when a common new technology
is adopted in both countries. That said, because in our sample, a country and its basecountry engage in signiﬁcant trade, we argue that most of the comovements in wages due

14

to the common trends in inﬂation and productivity can be incorporated in the frameworkof the modiﬁed Ricardian model.
Nevertheless, in the regressions in Tables 4 and 5, we include inﬂation and the
productivity growth of country 𝑖, which accounts for any comovements in inﬂation andproductivity with its base country. Because these regressions diﬀerentiate between thechannels, the estimated coeﬃcients of 𝛽2 , 𝛾2 and 𝛾3 now provide conservative measures ofwage comovements described by the model. From Tables 4 and 5, we can see that inﬂation
has strong eﬀects on the wage growth at all frequencies, while productivity growth has aweaker eﬀect on the wage growth over four-year periods. After controlling for inﬂation andproductivity growth, the wage comovements due to the trade-exchange-rate mechanism
appear in two-year periods. Because the modiﬁed Ricardian model focuses on stable,
long-term trade relationships, it is plausible that the predictions of wage comovements
only manifest themselves over a longer period of time.
Subsection 4.2 shows the regression results with the sample restricted to the EMU
countries. We ﬁnd that the coeﬃcients on currency-union pegs are all positive and thatthe signiﬁcance levels are higher, while the coeﬃcients on non-currency-union pegs change
little. This ﬁnding indicates that non-currency-union pegs did not work diﬀerently for thecountries that have never been in the EMU and the countries that joined the EMU in
1999. It also indicates that for EMU countries, there was a signiﬁcant increase in wage
comovements after joining the EMU in 1999, compared to the pre-euro era.
Overall, the empirical results support the predictions of the modiﬁed Ricardianmodel. As indicated by Tables 4 and 5, augmenting equations (6) and (7) with productivity
growth better aligns the empirical results with the theory, in the sense that both currency
union and non-currency-union pegs strengthen the positive wage comovements between
country pairs. Perhaps it is not surprising that non-currency-union pegs only weakly
enhanced wage comovements. As Obstfeld and Rogoﬀ (1995) suggest, pegs of this type15

often lack credibility. Historically, countries had been known to break their pegs anddevalue when the prices of their products were not competitive internationally. If producers
expect such devaluations, then there are smaller incentives to align wages to the basecountry.
Our results are relevant for the debate on whether the EMU is an optimum currency
area. The existence of wage comovements suggests that although relative to the US, theEMU originally was less likely to meet the criteria for optimum currency area (Feenstra
and Taylor, 2008, p.879), it may have enhanced the economic integration of its members
via wage comovements.
Finally, this paper is also related to the literature on the relationship between therelative price of non-traded goods and the bilateral real exchange rate. In two recent
papers on the subject, Betts and Kehoe (2006) and Betts and Kehoe (2008), one of thekey ﬁndings is that for pairs of countries who trade intensively or maintain a stable bilateralreal exchange rate, the relative price of non-traded goods has a stronger relationship with
their bilateral real exchange rate. In the modiﬁed Ricardian model in our paper, theimplicit real exchange rate is always one. Although there are no non-traded consumption
goods, both the theory and empirical work suggest that if a country ﬁxes its exchange
rate with its main partner, then the ratio of the two countries’ labor wages, which are
the prices of a non-traded factor, should also be stable. Namely, the nominal wages will
comove strongly and positively.

6

Conclusion

When a nominal exchange rate is incorporated into the standard Ricardian model of trade,the model predicts that two countries’ nominal wages must exhibit strong and positive
comovements to maintain this initial trading equilibrium if they ﬁx the bilateral exchange
rate. We use the data from 24 OECD countries between 1973 and 2010 to test this16

prediction. We ﬁnd that if a country and its main trade partner were in the EMU, theirwages experienced stronger comovements, especially over two-year intervals. For country
pairs who engage in non-currency-union pegs, their wages had weaker comovements, interms of both magnitude and statistical signiﬁcance. When we restrict our attention to
the EMU members, we also ﬁnd a signiﬁcant increase in wage comovements after theyjoined the EMU in 1999 compared to the period before 1999.

17

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Betts, Caroline M. and Timothy J. Kehoe, “U.S. Real Exchange Rate Fluctuations
and Measures of the Relative Price of Goods,” Journal of Monetary Economics, October
2006, 53 (7), 1297–326.
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Staﬀ Report 415, Federal Reserve Bank of Minneapolis October 2008.
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Anchors,” Contemporary Economic Policy, April 1994, 12 (2), 35–45.
Dornbusch, Rudiger, Stanley Fischer, and Paul A. Samuelson, “Comparative
Advantage, Trade, and Payments in a Ricardian Model with a Continuum of Goods,”
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Economist, “All pain, no gain?.,” The Economist, 2010, 397 (8712), 94.
Edwards, Sebastian, “Exchange Rates as Nominal Anchors,” Review of World Economics, March 1993, 129 (1), 1–32.
Feenstra, Robert C. and Alan M. Taylor, International Economics, New York, USA:Worth Publishers, 2008.
Ito, Motoshige and Michihiro Ohyama, International Trade, Tokyo, Japan: Iwanami
Shoten, 1985.

18

Klein, Michael W. and Jay C. Shambaugh, “The Nature of Exchange Rate Regimes,”
NBER Working Papers 12729, National Bureau of Economic Research, Inc December
2006.
Lamo, Ana, Javier J. Perez, and Ludger Schuknecht, “Public and Private Sector
Wages Co-movement and Causality,” Working Paper Series 963, European Central Bank
November 2008.
Obstfeld, Maurice and Kenneth Rogoﬀ, “The Mirage of Fixed Exchange Rates,”
Journal of Economic Perspectives, Fall 1995, 9 (4), 73–96.
Robertson, Raymond, “Wage Shocks and North American Labor-Market Integration,”
American Economic Review, September 2000, 90 (4), 742–64.
Sterne, Gabriel, “The Use of Explicit Targets for Monetary Policy: Practical Experienceof 91 Economies in the 1990s,” Bank of England Quarterly Bulletin 3, Bank of England
August 1999.
Willett, Thomas D., “Credibility and Discipline Eﬀects of Exchange Rates as Nominal
Anchors: The Need to Distinguish Temporary from Permanent Pegs,” World Economy,
August 1998, 21 (6), 803–26.

19

Table 1: Summary of peg episodes and data range
Country

20

EMU members since 1999
Austria
Belgium
FinlandFranceGermany
Ireland
Italy
Luxembourg
Netherlands
Portugal
Spain
Country in ERM II
Denmark
Other countries
Australia
CanadaJapan
Korea
MexicoHungary
New Zealand
NorwayPolandSwedenTurkeyUK

Base country

Episodes of non-currency-union pegs
with base country

Wage data range

Germany
Germany
Germany
GermanyUS
Germany
Germany
Belgium
Germany
Germany
Germany

1975-1998
1975-1980, 1984-1992, 1994-1998
1975, 1979, 1987, 1990, 1997-1998
1979-1980, 1984-1985, 1987-1994, 1996-1998

1996-1998

1973q1-2008q3
1973q1-2010q4
1973q1-2010q3
1973q1-2010q3
1973q1-2010q2
1979q1-2010q3
1973q1-2010q4
1980q1-2010q3
1973q1-2010q4
2000q1-2010q4
1981q1-2010q3

1975-1976, 1978, 1980, 1983-1992, 1994-2010

1973q1-2010q3

Germany
US
US
US
US
US
Germany
Australia
Germany
Germany
GermanyUS
Germany

1979-1980, 1984-1985, 1987-1992, 1998
1980, 1984, 1986, 1988, 1990-1991, 1997-1998
1973-1998
1975-1976, 1978-1998

1973-1974, 1983, 1986, 1990-1991, 1996
1992-1994
1999
1978-1980, 1988, 1992-1993
1975-1996, 1984, 1990-1991, 1994
1974-1975, 2003-2004

1984q1-2010q3
1973q1-2010q3
1973q1-2010q3
1992q1-2010q3
1980q1-2010q3
1995q1-2010q3
1989q1-2010q4
1973q1-2010q3
1995q1-2010q4
1973q1-2010q3
1988q1-2010q3
1973q1-2010q2

Notes: (1) Prior to 1979, the UK is the base country for Ireland, as the Irish pound had been pegged to the pound sterling. In all regressions, we discard
the Irish data before 1979 to avoid complications. (2) ERM II stands for Exchange Rate Mechanism II.

Table 2: Speciﬁcation 1

Variables
Δ 𝑙𝑛(𝑊𝑡∗ )𝑃 𝑒𝑔𝑡 × Δ 𝑙𝑛(𝑊𝑡∗ )𝐿𝑖𝑛𝑒𝑎𝑟 𝑡𝑖𝑚𝑒 𝑡𝑟𝑒𝑛𝑑
𝐶𝑜𝑛𝑠𝑡.
𝑂𝑏𝑠.
𝑅2
𝐹 𝑠𝑡𝑎𝑡𝑖𝑠𝑡𝑖𝑐

Quarterly(1)
0.27

Annual(2)0.23

2-year(3)
0.3

4-year(4)
0.28(0.13)∗∗(0.37)(0.39)

(0.4)

-.23

-.03

-.05

-.37

(0.14)∗(0.16)(0.16)(0.27)-.0002

-.003

-.01

-.05

(0.0000455)∗∗∗(0.001)∗∗∗(0.004)∗∗∗(0.02)∗∗∗

0.04

0.14

0.29

0.62

(0.005)∗∗∗(0.03)∗∗∗(0.07)∗∗∗(0.17)∗∗∗

2042
0.2
60.1

677
0.29
56.43

316
0.37
48.51

150
0.46
46.48

Notes: (1) The dependent variable is the wage growth rate as measured by the log change in wages. (2)The variable Δ 𝑙𝑛(𝑊𝑡∗ ) is the wage growth rate of the base country, and 𝑃 𝑒𝑔𝑡 is a dummy variableindicating whether a country pegs its exchange rate to its base country via a currency union or otherarrangements. (3) The top row indicates the time interval at which the wage growth rates are calculated.
(4) The numbers in the parentheses are robust standard errors. (5) *, **, and *** indicate statisticalsigniﬁcance at the 10%, 5% and 1% levels, respectively. (6) All regressions include country ﬁxed eﬀects.

21

Table 3: Speciﬁcation 2

Variables
Δ 𝑙𝑛(𝑊𝑡∗ )𝐶𝑈𝑡 ×Δ 𝑙𝑛(𝑊𝑡∗ )𝑁 𝑜𝑛 𝐶𝑈 𝑝𝑒𝑔𝑡 ×Δ 𝑙𝑛(𝑊𝑡∗ )𝐿𝑖𝑛𝑒𝑎𝑟 𝑡𝑖𝑚𝑒 𝑡𝑟𝑒𝑛𝑑
𝐶𝑜𝑛𝑠𝑡.
𝑂𝑏𝑠.
𝑅2
𝐹 𝑠𝑡𝑎𝑡𝑖𝑠𝑡𝑖𝑐

Quarterly(1)
0.23

Annual(2)0.15

2-year(3)
0.23

4-year(4)
0.16(0.13)∗(0.38)(0.39)(0.42)

0.64

0.78

0.96

0.68

(0.18)∗∗∗(0.33)∗∗(0.34)∗∗∗(0.22)∗∗∗

-.35

-.13

-.15

-.53

(0.12)∗∗∗(0.15)(0.17)(0.23)∗∗-.0002

-.004

-.02

-.06

(0.0000475)∗∗∗(0.001)∗∗∗(0.005)∗∗∗(0.02)∗∗∗

0.04

0.15

0.31

0.69

(0.005)∗∗∗(0.03)∗∗∗(0.08)∗∗∗(0.18)∗∗∗

2042
0.22
47.72

677
0.3
40.65

316
0.39
33.78

150
0.49
28.93

Notes: (1) The dependent variable is the wage growth rate as measured by the log change in wages. (2)The variable Δ 𝑙𝑛(𝑊𝑡∗ ) is the wage growth rate of the base country, 𝐶𝑈𝑡 is a dummy variable indicating
membership of a currency union, and 𝑁 𝑜𝑛 𝐶𝑈 𝑝𝑒𝑔𝑡 is a dummy variable indicating whether a country
engages in a peg other than being a member of a currency union. (3) The top row indicates the timeinterval at which the wage growth rates are calculated. (4) The numbers in the parentheses are robust
standard errors. (5) *, **, and *** indicate statistical signiﬁcance at the 10%, 5% and 1% levels,
respectively. (6) All regressions include country ﬁxed eﬀects.

22

Table 4: Speciﬁcation 1, with productivity growth and CPI inﬂation
Quarterly Annual 2-year
4-yearVariables
(1)
(2)
(3)
(4)
Δ 𝑙𝑛(𝑊𝑡∗ )
0.21
0.27
0.2
0.31
𝑃 𝑒𝑔𝑡 × Δ 𝑙𝑛(𝑊𝑡∗ )Δ𝑙𝑛(𝑎𝑡 )𝐶𝑃 𝐼 𝑖𝑛𝑓 𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒𝑡
𝐿𝑖𝑛𝑒𝑎𝑟 𝑡𝑖𝑚𝑒 𝑡𝑟𝑒𝑛𝑑
𝐶𝑜𝑛𝑠𝑡.
𝑂𝑏𝑠.
𝑅2
𝐹 𝑠𝑡𝑎𝑡𝑖𝑠𝑡𝑖𝑐(0.08)∗∗∗(0.14)∗∗

-.13

0.02

0.18

-.10

(0.13)(0.1)(0.11)∗(0.17)(0.18)(0.19)∗

-.06

0.02

0.02

0.12

(0.09)(0.05)(0.04)(0.06)∗∗

0.55

0.77

0.82

0.8

(0.15)∗∗∗(0.04)∗∗∗(0.03)∗∗∗(0.09)∗∗∗-.0001-.0008

-.003

-.007

(0.0000387)∗∗∗(0.0005)(0.002)(0.008)

0.02

0.03

0.06

0.1

(0.005)∗∗∗(0.02)∗∗(0.04)(0.09)

1899
0.38
175.3

622
0.72
260.2

295
0.77
288.08

139
0.84
146

Notes: (1) The dependent variable is the wage growth rate as measured by the log change in wages. (2)The variable Δ 𝑙𝑛(𝑊𝑡∗ ) is the wage growth rate of the base country, 𝑃 𝑒𝑔𝑡 is a dummy variable indicating
whether a country pegs its exchange rate to its base country via a currency union or other arrangements,
Δ𝑙𝑛(𝑎𝑡 ) is the productivity growth, and 𝐶𝑃 𝐼 𝑖𝑛𝑓 𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒𝑡 is the inﬂation rate as measured by thepercentage change of CPI. (3) The top row indicates the time interval at which the wage growth rates arecalculated. (4) The numbers in the parentheses are robust standard errors. (5) *, **, and *** indicate
statistical signiﬁcance at the 10%, 5% and 1% levels, respectively. (6) All regressions include country
ﬁxed eﬀects.

23

Table 5: Speciﬁcation 2, with productivity growth and CPI inﬂation
Quarterly Annual 2-year
4-yearVariables
(1)
(2)
(3)
(4)
∗
Δ 𝑙𝑛(𝑊𝑡 )
0.19
0.26
0.2
0.31
(0.08)∗∗

𝐶𝑈𝑡 × Δ 𝑙𝑛(𝑊𝑡∗ )𝑁 𝑜𝑛 𝐶𝑈 𝑝𝑒𝑔𝑡 × Δ 𝑙𝑛(𝑊𝑡∗ )Δ𝑙𝑛(𝑎𝑡 )𝐶𝑃 𝐼 𝑖𝑛𝑓 𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒𝑡
𝐿𝑖𝑛𝑒𝑎𝑟 𝑡𝑖𝑚𝑒 𝑡𝑟𝑒𝑛𝑑
𝐶𝑜𝑛𝑠𝑡.
𝑂𝑏𝑠.
𝑅2
𝐹 𝑠𝑡𝑎𝑡𝑖𝑠𝑡𝑖𝑐(0.15)∗(0.18)(0.19)

0.4

0.29

0.61

0.24

(0.24)(0.24)(0.24)∗∗(0.27)

-.16

0.02

0.18

-.09

(0.13)(0.1)(0.11)∗(0.17)

-.05

0.02

0.03

0.12

(0.1)

(0.05)(0.04)(0.07)∗

0.54

0.77

0.81

0.79

(0.15)∗∗∗(0.04)∗∗∗(0.03)∗∗∗(0.09)∗∗∗-.0001-.0009

-.003

-.01

(0.0000452)∗∗∗(0.0006)(0.002)∗(0.009)

0.02

0.04

0.06

0.11

(0.006)∗∗∗(0.02)∗(0.04)∗(0.09)

1899
0.38
141.62622
0.72
204.29295
0.77
229.19139
0.84
104.09Notes: (1) The dependent variable is the wage growth rate as measured by the log change in wages. (2)The variable Δ 𝑙𝑛(𝑊𝑡∗ ) is the wage growth rate of the base country, 𝐶𝑈𝑡 is a dummy variable indicating
membership of a currency union, 𝑁 𝑜𝑛 𝐶𝑈 𝑝𝑒𝑔𝑡 is a dummy variable indicating whether a country
engages in a peg other than being a member of a currency union, Δ𝑙𝑛(𝑎𝑡 ) is the productivity growth, and
𝐶𝑃 𝐼 𝑖𝑛𝑓 𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒𝑡 is the inﬂation rate as measured by the percentage change of CPI. (3) The top row
indicates the time interval at which the wage growth rates are calculated. (4) The numbers in theparentheses are robust standard errors. (5) *, **, and *** indicate statistical signiﬁcance at the 10%, 5%
and 1% levels, respectively. (6) All regressions include country ﬁxed eﬀects.

24

Table 6: Speciﬁcation 2, with productivity growth and CPI inﬂation, EMU countries only

Variables
Δ 𝑙𝑛(𝑊𝑡∗ )𝐶𝑈𝑡 × Δ 𝑙𝑛(𝑊𝑡∗ )𝑁 𝑜𝑛 𝐶𝑈 𝑝𝑒𝑔𝑡 × Δ 𝑙𝑛(𝑊𝑡∗ )Δ𝑙𝑛(𝑎𝑡 )𝐶𝑃 𝐼 𝑖𝑛𝑓 𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒𝑡
𝐿𝑖𝑛𝑒𝑎𝑟 𝑡𝑖𝑚𝑒 𝑡𝑟𝑒𝑛𝑑
𝐶𝑜𝑛𝑠𝑡.
𝑂𝑏𝑠.
𝑅2
𝐹 𝑠𝑡𝑎𝑡𝑖𝑠𝑡𝑖𝑐

Quarterly(1)
0.3

Annual(2)0.412-year(3)
0.49

4-year(4)
0.48(0.08)∗∗∗(0.12)∗∗∗(0.23)∗∗(0.23)∗∗

0.07

0.09

0.64

0.45

(0.15)(0.1)(0.12)∗∗∗(0.16)∗∗∗

-.38

-.11

0.12

-.003

(0.08)∗∗∗(0.09)(0.07)∗(0.06)

-.02

0.02

0.08

0.12

(0.1)

(0.02)(0.05)∗(0.06)∗

0.53

0.98

1.05

1.08

(0.13)∗∗∗(0.08)∗∗∗(0.1)∗∗∗(0.12)∗∗∗-.0001-.00020.00060.004(0.0000254)∗∗∗(0.0002)(0.001)(0.006)

0.01

0.002

-.04

-.08

(0.003)∗∗∗(0.008)(0.03)(0.08)

972
0.44
91.6

320
0.81
96.41

155
0.88
158.99760.94
753.86

Notes: (1) The dependent variable is the wage growth rate as measured by the log change in wages. (2)The variable Δ 𝑙𝑛(𝑊𝑡∗ ) is the wage growth rate of the base country, 𝐶𝑈𝑡 is a dummy variable indicating
membership of a currency union, 𝑁 𝑜𝑛 𝐶𝑈 𝑝𝑒𝑔𝑡 is a dummy variable indicating whether a country
engages in a peg other than being a member of a currency union, Δ𝑙𝑛(𝑎𝑡 ) is the productivity growth, and
𝐶𝑃 𝐼 𝑖𝑛𝑓 𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒𝑡 is the inﬂation rate as measured by the percentage change of CPI. (3) The top row
indicates the time interval at which the wage growth rates are calculated. (4) The numbers in theparentheses are robust standard errors. (5) *, **, and *** indicate statistical signiﬁcance at the 10%, 5%
and 1% levels, respectively. (6) All regressions include country ﬁxed eﬀects.

25