Juha Kilponen – Antti Ripatti
Labour and product market
competition in a small open
economy –
Simulation results using a DGE
model of the Finnish economy
Bank of Finland Research
Discussion Papers
5 • 2005

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Suomen Pankki
Bank of Finland
P.O.Box 160
FI-00101 HELSINKI
Finland
+ 358 10 8311

http://www.bof.fi

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Bank of Finland Research
Discussion Papers
5 • 2006


Juha Kilponen – Antti Ripatti


Labour and product market
competition in a small open
economy –
Simulation results using a DGE
model of the Finnish economy


The views expressed are those of the authors and do not
necessarily reflect the views of the Bank of Finland.

Aino model is a result of joint project by Juha Kilponen, Mika
Kuismanen (ECB), Antti Ripatti and Jouko Vilmunen. We are
also indebted to Juha Tarkka for plentiful of intensive
discussions and guidance during the various stages of the
model development project. We are also indebted to CEPR/ESI
2005 conference participants for many useful suggestions. The
usual disclaimer applies. Correspondence to
firstname.lastname@bof.fi or Bank of Finland, P.O. Box 160,
FIN-00101 Helsinki, FINLAND.

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http://www.bof.fi

ISBN 952-462-264-5
ISSN 0785-3572
(print)

ISBN 952-462-265-3
ISSN 1456-6184
(online)

Multiprint Oy
Helsinki 2006

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Labour and product market competition in a small
open economy – Simulation results using a DGE
model of the Finnish economy
Bank of Finland Research
Discussion Papers 5/2006
Juha Kilponen – Antti Ripatti
Monetary Policy and Research Department


Abstract
Using the DGE model of the Finnish Economy (the ‘Aino’ model), we study the
response of the economy to reforms in both labour and product markets. The
reforms are two-fold. We assume that the wage mark-up, ie the monopoly power
of wage-setters is gradually reduced by 5 percentage points. At the same time, the
degree of competition is increased, ie price margins are exogenously reduced by 2
percentage points. These reforms imply a very favourable outcome of the
economy. Both consumption and employment increases permanently and the
reforms are welfare enhancing. Public balances improve giving room for 1.5
percentage point cut in income taxes. Our simulation exercises clearly
demonstrate that such reforms may help in financing the future fiscal burden of an
ageing population.

Key words: competition, dynamic general equilibrium, public finance

JEL classification numbers: E60, C68

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Työ- ja hyödykemarkkinakilpailun kiristymisen
kokonaistaloudelliset vaikutukset pienessä
avotaloudessa: simulointituloksia Suomen talouteen
sovitetusta dynaamisesta yleisen tasapainon mallista
Suomen Pankin tutkimus
Keskustelualoitteita 5/2006
Juha Kilponen – Antti Ripatti
Rahapolitiikka- ja tutkimusosasto


Tiivistelmä
Tässä tutkimuksessa tarkastellaan Suomen talouden analysointiin rakennetun dy-
naamisen yleisen tasapainon mallin (Aino-mallin) avulla, miten kilpailun lisäänty-
minen työ- ja hyödykemarkkinoilla vaikuttaa talouteen ja erityisesti julkisen ta-
louden tasapainoon. Tutkimuksessa oletetaan, että palkkamarginaalit supistuvat
vähitellen 5 prosenttiyksikköä ja että hintamarginaalit kutistuvat 2 prosenttiyksik-
köä. Tämä johtaa taloudenpitäjien hyvinvoinnin kannalta suotuisaan lopputulok-
seen: sekä kulutus, reaalipalkat että työllisyys kasvavat. Julkisen talouden tasa-
paino paranee siten, että tuloveroa ja eläkemaksuja voidaan pienentää yhteensä
noin 1,5 prosenttiyksikköä. Tutkimus osoittaa, että talouden kilpailullisuutta tuke-
vat rakenteelliset reformit helpottaisivat osaltaan väestön ikääntymisen aiheutta-
maa lisääntyvää julkisen talouden rasitetta.

Avainsanat: kilpailu, dynaamiset yleisen tasapainon mallit, finanssipolitiikka

JEL-luokittelu: E60, C68

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Contents
Abstract....................................................................................................................3
Tiivistelmä (abstract in Finnish) ..............................................................................4

1 Introduction ......................................................................................................7

2 Consumers ........................................................................................................8
2.1 General
features.........................................................................................8
2.2 Population
dynamics..................................................................................9
2.3 Preferences...............................................................................................10
2.4 Consumption............................................................................................11
2.4.1
Assets ...........................................................................................11


2.4.2 Consumption of retirees ...............................................................12


2.4.3 Consumption of workers ..............................................................14
2.4.4
Distribution
of
wealth
and aggregate consumption......................15

3 Aggregate labour markets.............................................................................16

4 Public sector, pension fund and fiscal rule ..................................................18

4.1 Statutory pension funds ...........................................................................19

5 Calibration of demand side ...........................................................................20

6 Firms and technologies ..................................................................................22

6.1 Domestic intermediate goods producer ...................................................24
6.2 Capital
rental
firms ..................................................................................26
6.3 Domestic
retailers ....................................................................................28
6.4 Exporter ...................................................................................................30
6.5 Importing
firms........................................................................................31
6.5.1
Aggregator....................................................................................33
6.5.2
Foreign
importers .........................................................................33

6.6 Estimation of parameter values ...............................................................35

7 Market
equilibrium........................................................................................35

8 Product and labour market reforms ............................................................38
8.1 Background..............................................................................................38

8.2 Estimation of the mark-ups......................................................................39

8.3 Labour market reforms – simulation results............................................41

8.4 Product and labour market reforms combined – simulation results ........42
8.5 Sensitivity
analysis ..................................................................................44

9 Conclusions .....................................................................................................45

References..............................................................................................................48


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1
Introduction
The future challenges in the Finnish economy are closely connected with fiscal pol-
icy, demographic ageing, changes in production technology, as well as globalisation
which puts pressure both on the product and labour markets. In this paper, we con-
centrate on analysing product and labour market reforms and their simulated effects
on the aggregate behavior of the Finnish economy. In particular, we examine how
an increase in competition in the two markets affects various macroeconomic vari-
ables and public finances when the full general equilibrium features are accounted
for. In preparing quantitative results we use the recently build DGE model of the
Finnish economy called Aino. Similar exercise for aggregated Europe has been done
by Bayoumi, Laxton and Pesenti (2004a) and applied to Danish economy by IMF
(2004) using a model variant of Global Economic Model (GEM), build at the In-
ternational Monetary Fund (Bayoumi, Laxton, Faruqee, Hunt, Karam, Lee, Rebucci
and Tchakarov 2004b). Their results are qualitatively similar to ours. However,
some differences arise from the fact that unlike the GEM model, the Aino model has
distortionary taxes and consumers are essentially non-Ricardian. Moreover, Aino
model depicts the Finnish economy as a small open economy and treats the rest of
the world as given, while the GEM can be extended to a multi-country setup, with
explicit trade relationships between each structurally similar economies. Finally, we
intrepret the reforms as specific to Finland so that the monetary policy reactions of
the two reforms are not considered.
Aino depicts the Finnish economy as a dynamically optimizing small open econ-
omy which trades with rest of the world and has internationally given real interest
rate. The model has a non-stochastic balanced growth path at which the economic
growth is determined by exogenously given growth of labour saving technology and
population. Accumulation of financial assets and physical capital reflect optimal
intertemporal decisions of households and firms. The model contains exogenously
determined mark-up in the domestic goods markets as well as labour markets. The
first mark-up is given by the time-varying elasticity of substitution of different prod-
uct brands and it can vary temporarily due to Calvo-type price rigidities. Similar
structure holds for the labour markets as well.
Households’ saving decisions, and thus accumulation of financial assets, are in-
fluenced by households’ desire to smooth consumption over time. Individuals are
expected to have finite lives which consist of two distinct periods. We label the
households living in these two different periods as ‘workers’ and ‘retirees’, as in
Gertler (1999). Workers and retirees differ essentially in terms of their effective
planning horisons, marginal propensity to consume, as well as in terms of marginal
productivity of labour. There are inter-generational transfers between workers and
retirees, which are however kept constant throughout the simulations in this paper.
The same applies to all other public transfers in the model. Finally, the public deficit
is closed by an income tax rule, which reacts to public deficit as well as deviation of
public debt from some prespecified target.
Simulation results suggest that reforms that increase competition both in the prod-
uct and labour markets are welfare enhancing, as increasing competition leads to
increased consumption, investments, employment and production potential of the
economy in the long-run. However, increasing competition is associated with ini-
tial decline in private consumption and a slight drop in labour effort. This is due to
the wealth effect caused by the temporary reduction in profits, as well as temporary
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increase in the real interest rate caused by the slow down of expected domestic in-
flation. Public sector finances are also improved, in the sense that the public sector
balance is now reached at lower tax rate. Our standard simulation suggest that two
and five percentage point decline in the price and wage mark-up respectively allows
roughly a 1.5 percentage point drop in the wage income tax rate. The sensitivity
analysis shows that the results appear most sensitive to changes in elasticity of sub-
stitution between consumption and leisure. This is the critical parameter affecting
the (Frisch) elasticity of labour supply.
Rest of the paper is organised as follows. Sections 2–7 set up the model. Section
8.1 presents the simulation experiment in detail and discusses the results. The final
section concludes.
2
Consumers
2.1
General features
In Aino, in the spirit of general equilibrium theory, consumers make optimal deci-
sions on consumption and labour supply. The theory does not describe any particular
household, but only what happens on average. As is typical in modern macroe-
conomic models, consumers in Aino model seek to hold their life-cycle consump-
tion as stable as possible. Consumers are viewed as being free from periodic credit
constraints, and so households can smooth consumption against stochastic sources
of risk. Consumption decisions depend on household’s discounted wealth over the
lifespan, ie, in addition to financial assets, on the expected present value of future
labour income and income transfers. This permanent income feature of households’
consumption behaviour loosens the relationship between consumption and current
income. Transitory changes in income will have only a small effect on their cur-
rent consumption, whereas more persistent and, in the limit, permanent changes in
income will change current consumption by a sizable amount.
Individuals’ finite life-cycles consist of two distinct periods, “active working age”
and “retirement period”, as in Gertler (1999). Consumption and labour supply de-
cision of individuals are affected by the future prospect of their retirement, as well
as the fact that labour efficiency is assumed to fall in retirement. In particular, the
likelihood that the worker may lose part of his labour income due to retirement, in-
duces her to discount the future income stream at higher rate than otherwise. This
reduces consumption and increases saving. In this sense, active working age popula-
tion saves for retirement. Similarly, finite expected lifetime makes the worker value
the future less relative to present, as compared to infinite horizon representative agent
case. Retirees, on the other hand, discount future more heavily than active working
age indviduals due to the constant periodic probability of death. Therefore, in the
model, pensioners’ propensity to consume out of wealth is greater than that of the
active working-age population.
Under these assumptions, increased public consumption, financed eg by central
government debt, will stimulate the economy in the short term. Consumers will take
into account the higher future taxes that will result from increased public consump-
tion by increasing their savings in the medium term. The short-term expansionary
effect of an increase in public expenditure depends critically on households’ saving
propensity. The stronger household saving responds to changes in real interest rates,
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Document Outline

• Labour and product market competition in a small open economy - Simulation results using a DGE model of the Finnish economy
• Abstract
• Tiivistelmä (Abstract in Finnish)
• Contents
• 1 Introduction
• 2 Consumers
  • 2.1 General features
  • 2.2 Population dynamics
  • 2.3 Preferences
  • 2.4 Consumption
    • 2.4.1 Assets
    • 2.4.2 Consumption of retirees
    • 2.4.3 Consumption of workers
    • 2.4.4 Distribution of wealth and aggregate consumption
• 3 Aggregate labour markets
• 4 Public sector, pension fund and fiscal rules
  • 4.1 Statutory pension funds
• 5 Calibration of demand side
• 6 Firms and technologies
  • 6.1 Domestic intermediate goods producer
  • 6.2 Capital rental firms
  • 6.3 Domestic retailers
  • 6.4 Exporter
  • 6.5 Importing firms
    • 6.5.1 Aggregator
    • 6.5.2 Foreign importers
  • 6.6 Estimation of parameter values
• 7 Market equilibrium
• 8 Product and labour market reforms
  • 8.1 Background
  • 8.2 Estimation of mark-ups
  • 8.3 Labour market reforms - simulation results
  • 8.4 Product and labour market reforms combined - simulation results
  • 8.5 Sensitivity analysis
• 9 Conclusions
• References
• Bank of Finland Discussion Papers

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