Federal Reserve Bank of San Francisco. "1995, Number 1," Economic Review (Federal Reserve Bank of San Francisco) (1995). https://fraser.stlouisfed.org/title/869/item/520415, accessed on April 27, 2025.

Title: 1995, Number 1

Date: 1995
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image-container-13 HUH AND TREHAN / TIME SERIES BEHAVIOR OF THE AGGREGATE WAGE RATE 13 discussed in prior sections. Our results indicate that shocks to the price level have a significant effect on wages. By contrast, the proportion of the price level forecast error attributable to the nominal wage shock is relatively small, even when the nominal wage is placed first. There is, of course, significant contemporaneous cor- relation between the innovations to these two variables; if this correlation were assumed to be the result of shocks to the wage rate, then wage shocks couid be said to have a non-~egligible effect on pricesP However, this inference can be reconciled with the Granger causality tests pre- sented above only if firms complete the required price adjustment (to wage shocks) within the quarter in which the wage shocks occur. Such rapid adjustment seems rather unlikely to us. Finally, there is no evidence to suggest that shocks to the nominal wage rate have any permanent effect on either real wages or productivity. ill. SUMMARY AND CONCLUSIONS We have argued that the time-series behavior of aggregate wages should be studied in relation to the time-series behavior of productivity. If productivity is nonstationary, relatively tight restrictions on the joint behavior of these variables can be derived from models in which the repre- sentative firm is on its demand curve in the long run. We find that data for the postwar U.S. economy are consistent with the hypothesis that the representative firm is on its demand-for-Iabor curve in the long run. This finding-which in terms of the empirics is that productivity, wages and prices are cointegrated-allows us to cast the data in the form of a vector error correction model. Using this specification we find that (Granger) causality runs from prices and productivity to wages but not the other way around. Further, our analysis reveals that the measured impact of cyclical variables, such as the unemployment rate, is sensitive both to how the long run is modeled and to the inclusion of a measure of productivity in the wage equation. Our analysis also reveals that nomi- nal wage innovations have little, if any, influence on the long-run behavior of real wages (or, by implication, of productivity). Instead, the long-term behavior of the real wage rate is determined largely by innovations to produc- tivity, and these innovations act almost entirely through changes in the price level. 17. The one exception to this statement is the case where we restrict the error correction term to be zero in the price and productivity equations. In this case, wage shocks have almost no long-run effect on prices. REFERENCES Abowd, 1.M. 1987. "Collective Bargaining and the Division of the Value of the Enterprise." NBER Working Paper No. 2137. Banerjee, Anindya, Juan Dolado, John W. Galbraith, and David E Hendly. 1993. Cointegration, Error-Correction, and the Econo- metric Analysis ofNon-stationary Data. New York: Oxford Uni- versity Press. Bils, Mark. 1990. "Wage and Employment Patterns in Long-Term Contracts when Labor Is Quasi-Fixed." NBER Macroeconomics Annual, pp. 187-226. Blanchard, Olivier, and Stanley Fischer. 1989. Lectures on Macro- economics. Cambridge: MIT Press. Christiano, Lawrence 1. 1988. "Searching for a Break in Real GNP." NBER Working Paper No. 2695. Engle, Robert E, and C. W. 1. Granger. 1987. "Cointegration and Error Correction: Representation, Estimation and Testing." Economet- rica (March) pp. 251-276. Engle, Robert E, and Byung Sam Yoo. 1988. "Forecasting and Testing in Co-integrated Systems." Journal of Econometrics, pp. 143- 159. Espinosa, Maria Paz, and Changyong Rhee. 1989. "Efficient Wage Bargaining as a Repeated Game." Quarterly Journal ofEconomics (August) pp. 565-588. Evans, George W. 1989. "Output and Unemployment Dynamics in the United States:1950-1985." Journal ofAppliedEconometrics 3, pp. 213-237. Fuller, Wayne A. 1976. Introduction to Statistical Time Series. New York: John Wiley & Sons. Gonzalo, Jesus. 1989. "Comparison of Five Alternative Methods of Estimating Long-Run Equilibrium Relationships." Unpublished manuscript. University of California San Diego (November). Gordon, Robert 1. 1988. "The Role of Wages in the Infll(ltion Process." American Economic Review Papers and Proceedings, pp. 276- 283. Hansen, Lars P., and Thomas 1. Sargent. 1989. "Two Difficulties in Estimating Vector Autoregressions." In Rational Expectations Econometrics. Boulder: Westview Press. Johansen, Sl'lren, and Katarina Juselius. 1990. "Maximum Likelihood Estimation and Inference on Cointegration-with Applications to the Demand for Money." Oxford Bulletin of Economics and Statistics, pp. 169-210. MaCurdy, Thomas E., and John H. Pencavel. 1986. "Testing between Competing Models of Wage and Employment Determination in Unionized Markets." Journal ofPolitical Economy, pp. S3-S39. Mehra, Yash. 1991. "Wage Growth and the Inflation Process." Ameri- can Economic Review, pp. 931-937. Nickell, Stephen. 1986. "Dynamic Models of Labor Demand." In Handbook ofLabor Economics, eds. Orley Ashenfelter and Rich- ard Layard. Amsterdam: Elsevier Science Publishers B.V. Perron, Pierre. 1989. "The Great Crash, the Oil Price Shock and the Unit Root Hypothesis." Econometrica, pp. 1361-1401. Phillips, A.W. 1958. "The Relationship between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957." Econometrica, pp. 283-299. Phillips, Peter C. B. 1987. "Time Series Regressions with a Unit Root." Econometrica, pp. 277-301.
image-container-14 Comovements among National Stock Markets Kenneth Kasa Economist, Federal Reserve Bank of San Francisco. I would like to thank Tim Cogley, Mark Levonian, and Carl Walsh for helpful suggestions. Barbara Rizzi provided excellent research assistance. This paper uses the methodology of Hansen and Jagan- nathan (1991) to derive a lower bound on the correlation between any pair of asset returns under the hypothesis of complete markets. The bound is a simple function of the two assets Sharpe ratios and the coefficient ofvariation of a unique stochastic discount factor. The paper uses this bound to conduct robust 1 nonparametric tests of the hy- pothesis that international equity markets are integrated. Using monthly stock return datafrom the U.S., Japan, and Great Britain for the period 1980 through 1993, I find that conclusions about market integration depend sen- sitively on the assumed variation of the (unobserved) common world discount rate. Given the observed correla- tions in returns, markets are more likely to be integrated the more volatile is the discount rate. International capital markets play an important role in the world economy. It is through these markets that risk and investment resources are allocated across countries. Gaug- ing the extent to which international bond and equity markets perform these functions efficiently has therefore been a topic of great interest to economists. Traditionally, this question has been posed as whether or not national capital markets are "integrated" or "segmented." That is, do assets issued in different countries yield the same risk- adjusted returns, or do they consistently yield different returns because of informational and governmentally im- posed barriers? Clearly, if international capital markets are to provide appropriate signals to savers and investors, national bond and equity markets must be integrated. Attempts to answer this question are plagued by two difficulties not encountered in studies of domestic capital market efficiency. First, assets issued in different countries tend to be denominated in different currencies, and ex- change rate volatility adds an additional element of uncer- tainty to international investments. As a result, when testing the integration hypothesis one must either include a model of the pricing of exchange rate risk, or consider returns that have been "covered" against exchange rate risk. Second, because of taste differences and transporta- tion costs, consumption patterns differ across countries much more than they do across regions within a single country. Since investors want to hedge their real consump- tion risks, this means that the riskiness of a given asset depends on the owner's country of residence. These prob- lems make it even more difficult than usual to define a risk- adjusted return, and consequently, make the results in this literature difficult to interpret. Studies of international bond markets generally con- clude that markets are becoming increasingly integrated. This is particularly true when exchange risk and consump- tion differences are not an issue, e.g., when testing Cov- ered Interest Parity. 1 Tests of Uncovered Interest Parity, however, have led to more ambiguous results. Although the hypothesis is typically rejected, no one has yet formulated 1. See Frankel (1993) for a survey of the evidence on short-term covered interest parity. Popper (1993) provides evidence on long-term covered in- terest parity.
image-container-15 an economic model of exchange rate risk that can explain these rejections. This has led some observers to question the efficiency of the foreign exchange market. 2 Even more stringent tests of international bond market integration, which require assumptions about both foreign exchange risk and international consumption differences, are con- ducted by Cumby and Mishkin (1986). They document close, but imperfect, linkages among the (ex ante) real interest rates of the U. S. and Europe. Glick and Hutchison (1990) apply the same methodology to real interest rate linkages between the U. S. and a set of Pacific Basin countries and find that financial liberalization has in- creased the linkages among these markets. In this paper, I examine the integration of international stock markets. Early work on this topic followed the same basic logic as bond market studies. That is, the extent of integration was judged by the correlation of returns, the idea being that greater equity market integration should lead to greater correlation among national stock markets. 3 Although this idea seems plausible, and in fact remains the conventional wisdom within the business community, we know. from the work of Lucas (1982) that the important implication of integrated capital markets is the equaliza- tion among countries of marginal rates of substitution in consumption, both intertemporally and across states of nature. Stock returns in an integrated market mayor may not be highly correlated, depending upon the nature of international specialization and the correlation of national productivity shocks. For example, stock markets may be segmented, yet stock returns could nonetheless be highly correlated if countries produce similar goods or if produc- tivity shocks are highly correlated across countries. Con- versely, stock markets might be integrated even if national stock returns are weakly correlated if countries are spe- cialized in the production of different goods and if produc- tivity shocks are weakly correlated across countries. This suggests that the coherence among national consumption growth rates probably provides a better metric for the degree of international capital market integration than does the correlation of stock returns. Obstfeld (1993) pursues this strategy and concludes that the weak relationships observed among national consump- tion growth rates are inconsistent with the hypothesis of internationally integrated capital markets, although he does find that markets have become more integrated over time. However, as Obstfeld himself acknowledges, this 2. Froot and Thaler (1990) survey the evidence on Uncovered Interest Parity. 3. See lorion (1989) for a survey of early work on international stock market integration. KAsA/COMOVEMENTS AMONG NATIONAL STOCK MARKETS 15 approach suffers from a couple of severe drawbacks. First, in order to link consumption data to the marginal rate of substitution, one must specify a utility function. That is, this strategy is "parametric," and as a result one can never be sure whether a given rejection represents a bona fide rejection of the hypothesis of integrated markets or merely represents a rejection of the posited utility function. Sec- ond, it is widely recognized that consumption data contain measurement error. This creates econometric difficulties in implementing this approach. This paper adopts a strategy that avoids these problems. Not only is it nonparametric, and therefore robust to functional form misspecification and measurement error biases, but it also resurrects the intuitive notion that integration of equity markets should place restrictioJ:ls on the observed correlation among national stock markets. In particular, I adapt the methodology of Hansen and Jagan- nathan (1991) to derive a lower bound on the correlation be- tween national stock market returns under the hypothesis of integrated markets. If the observed correlation between a pair of stock market returns is below its lower bound, then we can conclude that these markets do not share the same discount rate, or in other words, are not integrated. The basic idea behind this approach is as follows. Hansen and Jagannathan derive a lower bound on the volatility of an unobserved stochastic discount factor. This discount factor translates future state-contingent payoffs into current asset prices. Economic theories of asset pric- ing are distinguished according to how they link this discount factor to observable variables. For example, in the approach taken by Obstfeld the discount rate is assumed to be equal to the intertemporal marginal rate of substitution in consumption, while in the static CAPM it is assumed to be proportional to the return on the "market portfolio." Now, the hypothesis of integrated markets means that this discount factor is the same across countries, which implies that the Hansen-Jagannathan bound must be the same across countries. In particular, the lower bound on the standard deviation of the common world discount rate becomes a function of the observed variances and covari- ances of national stock market returns. In essence, all I do in this paper is invert this volatility bound to derive a lower bound on the correlation coefficient ofreturns as a function ofthe standard deviation of the unobserved discount factor. If the observed correlation is below this bound, then we must reject the joint hypothesis of integrated markets and the given value for the volatility of the stochastic discount factor. Before proceeding, one should understand the caveats to this approach. First, as always we are testing a joint hypothesis. This manifests itself here as the need to specify
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Date: 1995
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  • Authors: Huh, Chan-Guk, Trehan, Bharat
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  • Author: Kasa, Kenneth Allan
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  • Author: Laderman, Elizabeth
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