The wage-price block of the Area Wide Model

The unique feature of the AWM is that it treats the Euro area as a single econ­omy. Since the Euro was introduced only on 1 January 1999 and the information set underlying the estimation of the model—as documented in Fagan et al. (2001)—is a constructed data set covering the period 1970(1)-1998(4), the counterfactual nature of this modelling exercise is evident.

The AWM is used for forecasting purposes and the model has been specified to ensure that a set of structural economic relationships holds in the long run. It is constrained to be consistent with the neoclassical steady-state in which the long-run output is determined via a production function by exogenous techno­logical progress and the available factors of production, where the growth rate of labour force is exogenous. Money is neutral in the long run and the model’s long-run properties is further pinned down by an exogenous NAIRU.

Our focus is on the modelling of inflation, which is modelled jointly with wage growth in the AWM. Whereas the long-run equilibria are largely deter­mined by a priori considerations through the output production function and the exogenous growth rates in factor productivity, the labour force and the NAIRU, the short run is modelled empirically as (single equation) equilibrium - correction models. The empirical models are re-estimated in Jansen (2004) on an extended data set (1970(1)-2000(4)) and the results do not deviate much from those in Fagan et al. (2001); see appendix B in Jansen (2004).

Wages are modelled as a Phillips curve in levels, with wage growth depend­ing on the change in productivity, current, and lagged inflation—in terms of the consumption deflator pt—and the deviation of the unemployment ut from its NAIRU level Ut, that is, (ut — ut) defines the equilibrium-correction term, ecmwAWM. Inflation and productivity growth enter with unit coefficients, so the equation is expressed with the change in the wage share Awst, which equals the change in real unit labour cost, Aulct — Apt, as left-hand side variable. ulct is nominal unit labour cost and, as before, natural logarithms of variables are denoted by lower-case symbols.

The output price or GDP at factor costs, qt, is a function of trend unit labour costs, ulct, both in the long run (levels) and the short run (changes). The equilibrium-correction term equals (qt — (ulct — (1— в))), where (1—в) is the elasticity of labour in the output production function, thus linking the long-run real equilibrium to the theoretical steady-state. The markup is also influenced by an output gap and import price inflation (Apit) has short-run effects on Aqt. Finally, consumer price inflation (i. e. the consumption deflator) Apt is determined by the GDP deflator at market prices, and import prices, both in the short run and in the long run (with estimated weights equal to 0.94 and 0.06, respectively). There is also a small effect of world market raw materials prices in this equation. Noting that the GDP deflator at market prices by definition equals GDP at factor prices corrected for the rate of indirect taxation (qt + tt), we find by substituting for qt that the equilibrium correction term for Apt can be written as

ecmpAWM = pt + 0.59 • 0.94 - 0.94UJCt - 0.06pit - 0.94tt. (8.9)

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