Since the 1970s models that feature relative prices, which in the past were mainly used by international trade theorists, have increasingly found their way into open economy macroeconomics. Many such supply-oriented models emphasize the distinction between internationally traded and non-traded goods. Two-sector models offer an interesting alternative to the conventional one-sector Keynesian model and may provide a better framework for explaining aggregate fluctuations in a mature industrial economy. The literature using these models has been mainly theoretical, partly due to the difficulty of measuring categories such as `tradable' and `non-tradable' goods. This should not, however, prevent empirical scrutiny of the macroeconomic implications of such models.
In Discussion Paper No. 256, Research Fellow George Alogoskoufis investigates the relationships between wage adjustment, competitiveness and aggregate fluctuations in a model in which the traded goods sector is essentially competitive and the non-traded goods sector is oligopolistic. The model also distinguishes between private and public nontradable goods, both of which are primarily services. Competitiveness is defined as the relative price of traded to non-traded goods. Government expenditure and the relative price of oil play prominent roles in the model.
When GDP rises towards its full employment level, competitiveness falls, since workers demand higher real wages. Similar effects occur when the relative price of oil increases, as the consumer price index rises relative to the price of domestic value-added. Workers demand a rise in nominal wages to maintain their living standards, and this raises the relative price of non-traded goods. In Alogoskoufis's model, a rise in real government expenditure will lead to a new equilibrium in the output market, in which output is higher and competitiveness is lower, as workers demand higher real wages. On the other hand, a rise in the wedge between consumption and product wages will shift the labour market to a new equilibrium with reductions in both&nbspoutput and competitiveness. Similar effects appear as a result of an exogenous increase in wage demands by workers.
The model accounts quite well for fluctuations in UK competitiveness, output, wages, and terms of trade for 1952-85, and is used to examine the macroeconomic effects of a variety of disturbances. A fiscal expansion causes output to overshoot its equilibrium value; after the original expansion in output, however, real wages start to rise, competitiveness gradually falls, and so does output. Purely nominal shocks, such as unanticipated exchange rate depreciations or nominal wage shocks, have transitory output effects which, because of the sluggishness in real wages, persist for some years. An increase in world inflation, combined with an increase in the relative price of oil, results in persistent stagflation.
Alogoskoufis finds that the two-sector model goes a long way towards analysing the important relationships between output, real wages and competitiveness. There is very strong evidence of a negative relation between real wages and competitiveness, a positive relation between output and competitiveness, and a negative relation between real wages and deviations of output from its full employment level. His estimates reveal that output flexibility and real wage rigidity are important characteristics of the UK economy, as is sluggish adjustment in the prices of internationally traded goods

Traded Goods, Competitiveness and Aggregate Fluctuations in the United Kingdom
George Alogoskoufis

Discussion Paper No. 256, July 1988 (IM)