The continued persistence of the post-1973 slowdown in world-wide economic growth has led to increasing pressure in many countries to maintain growth while preserving external balance, by using commercial policy to protect domestic production. The argument is straightforward - higher tariffs increase the price of foreign goods relative to domestic goods, which in turn leads to higher domestic output, income and therefore savings. Higher savings imply a current account improvement, although under flexible exchange rates an appreciating currency may partially offset this.

In a recent Discussion Paper, Research Fellow Sweder van Wijnbergen argues that implausible assumptions concerning wage behaviour are crucial to this argument. Often real wage indexation is the source of conflict between internal and external balance. Van Wijnbergen examines the consequences of tariffs when such wage indexation is effective. He retains the structure of the traditional Mundell-Fleming model in order to facilitate comparisons with earlier work. Savings behaviour is not arbitrary but instead is derived from forward-looking maximizing behaviour: all agents in the economy formulate plans for the current period and for the future.

As a benchmark, van Wijnbergen first considers a situation in which real wages are flexible and do adjust to clear the labour market. A permanent increase in tariffs will, under reasonable assumptions, leave the current account unaffected. A temporary tariff increase does lead to a current account improvement. How does this occur? The tariff changes the terms of trade and thus changes real incomes. This income effect, however, is stronger in the current period than in the future and leads to an improvement in the current account. Moreover, the temporary nature of the tariff changes the rate at which consumers can substitute current for future consumption and thereby increases savings "today'. Both factors lead to a current account improvement, but this stems only from the fact that the tariff is temporary.

Van Wijnbergen shows that real wage indexation changes these results. He assumes that wage contracts are negotiated at the beginning of each period, at a level which will lead to full employment if no unanticipated shocks occur; wages are also indexed on the consumer price index. Tariffs cause the price level to rise and so increase real wages because of the indexation. This in turn implies that a permanent tariff increase, if unanticipated when wage contracts are concluded, will inevitably reduce employment, as the indexed wage rises. As a consequence output and therefore income declines, contributing to a current account deficit. In the limiting case of a small country which faces an infinitely elastic foreign demand for its exports, van Wijnbergen shows that the negative effect dominates. In that case a permanent increase in tariffs will lead to more unemployment, a fall in first-period real output and a current account deficit!

Temporary first-period increases in tariffs will also, under real wage indexation, reduce employment and first-period real output. Because they are only temporary, they also alter the rate at which consumers can substitute current for future consumption. This substitution may offset the tendency for the current account to deteriorate because of the first-period fall in income and employment. Even if the overall effect does improve the current account, however, it will always be less than the current account response in the absence of real wage indexation. In this sense, then, wage indexation can work against the desired effects of the tariff.


Tariffs, Employment and the Current Account: Real Wage Resistance and the Macroeconomics of Protectionism
S van Wijnbergen

Discussion Paper No. 30, September 1984 (IT)