The Behavior of Nontradable Goods Prices in Europe: Evidence and Interpretation


WP/93/45-EA

The Behavior of Nontradable Goods Prices in Europe:
Evidence and Interpretation by José De Gregorio,
Alberto Giovannini, and Thomas H. Krueger

This paper examines the evolution of the relative price between
tradable and nontradable goods in a group of European countries. A model
of an open economy is used to analyze different factors that can account
for an increase in the relative price of nontradable goods.

The labor market plays a crucial role in the economy, transmitting
shocks to the real wage and the real exchange rate. This paper postulates
a centralized bargaining arrangement, where unions act as monopolists by
setting the wage rate and employers decide the level of employment. The
key element of this market is that the unions' target real wage and target
level of employment are above the labor demand schedule. The target real
wage could be determined, for example, by expectations of an unsustainable
real exchange rate. The model also allows for a government that finances
spending on nontradable goods through lump-sum taxation and productivity
growth in both sectors.

The model is applied to the data to analyze the joint behavior of
the current account, the relative price of nontradable goods, average
labor productivity across sectors, government spending, and the sectoral
composition of aggregate output. Econometric evidence on the determinants
of the real exchange rate is also provided. The findings broadly reveal
that demand shifts in the private sector as well as faster productivity
growth in the tradable goods sector underlay the appreciation of the real
exchange rates in Europe. In addition, the slow adjustment of nontradable
goods prices may have played an important role in France during the second
half of the 1970s and the early 1980s, in Italy since the late 1970s, and
in Spain and the United Kingdom during the second half of the 1980s. In
contrast, government expenditure does not appear to have played a major
role, through its impact on the demand for nontradable goods, in the
evolution of the real exchange rate.