Search

This paper develops an interpretation of the Asian meltdown focused on moral hazard as the common source of overinvestment, excessive external borrowing, and current account deficits. To the extent that foreign creditors are willing to lend to domestic agents against future bail-out revenue from the government, unprofitable projects and cash shortfalls are re-financed through external borrowing. While public deficits need not be high before a crisis, the eventual refusal of foreign creditors to refinance the country's cumulative losses forces the government to step in and guarantee the outstanding stock of external liabilities. To satisfy solvency, the government must then undertake appropriate domestic fiscal reforms, possibly involving recourse to seigniorage revenues. Expectations of inflationary financing thus cause a collapse of the currency and anticipate the event of a financial crisis. Keywords: Moral hazard: Balance of payment crisis; International lending; Speculative attacks:, Asia

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.euroecorev.2010.04.001 Byline: Alexander Hijzen (a), Paul Swaim (b) Keywords: Employment protection legislation; International outsourcing; Labour demand; Worker insecurity Abstract: This paper analyses the evolution of the elasticity of labour demand and the possible role of offshoring therein using industry-level data for a large number of OECD countries. The first main finding is that the wage elasticity of labour demand has increased substantially since 1980, although some of this increase may reflect a trend increase in the speed of adjustment rather than an increase in the long-run wage elasticity. The evidence on the potential contribution of offshoring to raising labour demand elasticity is mixed. No association is found between increases in offshoring and demand elasticity during the second half of the 1990s, but there is a significant cross-sectional association between higher average offshoring intensity during this period and higher demand elasticity. We also find some evidence that strict employment protection legislation weakens the cross-sectional association between offshoring and higher labour demand elasticity, suggesting that the relationship between offshoring and the labour demand elasticity may depend on the national institutional environment. Author Affiliation: (a) OECD and GEP, University of Nottingham, 2 rue Andre-Pascal, 75775 Paris, Cedex 16, France (b) OECD, Paris, France Article History: Received 11 December 2007; Accepted 18 April 2010 Article Note: (footnote) [star] The present paper provides an extension to the analysis of the elasticity of labour demand that was published in Chapter 3 of the OECD Employment Outlook 2007, 'OECD workers in the global economy: increasingly vulnerable?' The authors would like to thank Sebastien Martin for excellent research assistance and two anonymous referees, Andrea Bassanini, Martine Durand, Sam Hill, Molly Lesher and John Martin for very helpful comments and suggestions. The opinions expressed in this paper are those of the authors and do not necessarily reflect those of the OECD or its member states. All remaining errors are our own.

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.euroecorev.2009.06.010 Byline: Signe Krogstrup (a), Charles Wyplosz (b) Abstract: The budget deficit bias is modeled as the result of a domestic common pool problem and of an international externality. Deficits can be used to finance both unproductive and productive public spending. An optimally set supranational deficit ceiling is examined and welfare is compared to the unconstrained outcome and to the case of nationally set deficit ceilings. The supranational deficit ceiling is found to be welfare improving relative to similar national arrangements, but does not fully eliminate the deficit bias unless combined with a domestic fiscal institution allowing for precommitment to productive public spending. Author Affiliation: (a) Swiss National Bank, Bundesplatz 1, 3003 Bern, Switzerland (b) The Graduate Institute of International and Development Studies and CEPR, 11A Avenue de la Paix, CH-1202 Geneva, Switzerland Article History: Received 30 August 2007; Accepted 16 June 2009 Article Note: (footnote) [star] The main part of this paper was written while Krogstrup was at the Graduate Institute of International Studies. The views expressed in this paper are those of the authors and do not necessarily represent those of the Swiss National Bank.

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.euroecorev.2009.06.004 Byline: Yingying Dong Keywords: Kindergarten retention; Retention policy; Average treatment effect on the treated; Control function; Nearest-neighbor matching Abstract: While most existing research concludes that grade retention generates no benefits for the retainees' academic performance, holding low-achieving children back has been a popular practice for decades. Drawing on a recently collected nationally representative dataset in the US, this paper estimates the causal effect of repeating kindergarten on the retained children's academic performance. Since we observe children being held back only when they enroll in schools that permit kindergarten retention, this paper jointly models the choice of enrolling in a school that allows kindergarten retention, the decision of repeating kindergarten, and children's academic performance in higher grades. A control function approach is developed to estimate the resulting double-hurdle treatment model, which accounts for unobserved heterogeneity in the retention effect. A nearest-neighbor matching estimator is also implemented. Holding children back in kindergarten is found to have positive but diminishing effects on their academic performance up to third grade. Author Affiliation: Department of Economics, California State University - Fullerton, CA 92831, USA Article History: Received 18 December 2006; Accepted 2 June 2009

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.euroecorev.2009.04.009 Byline: Campbell Leith (a), Simon Wren-Lewis (b) Keywords: Taylor rules; Inflation targeting; Interest rate rules Abstract: Taylor rules, which link short-term interest rates to fluctuations in inflation and output, have been shown to be a good guide (both positively and normatively) to the conduct of monetary policy. As a result they have been used extensively to model policy in the context of both closed and open economy models. Their determinacy properties have also been analysed in the context of closed and, to a more limited degree, in small open economy models. In this paper, we extend the analysis of the determinacy properties of Taylor rules to the case of a benchmark two-country model. When the rules are specified in terms of output-price inflation we confirm and extend the conventional results from the closed economy literature -- satisfying the Taylor principle is the key to ensuring determinacy, although the presence of backward-looking price-setting can affect the determinacy properties of the two-country model. However, the conventional results do not hold when we replace output-price inflation with consumer price inflation in the specification of the rule. In this case, Taylor rules which satisfy the Taylor principle will be indeterminate, unless there is an unusually large home bias in consumption. Similar indeterminacy problems arise when one country targets CPI inflation and the other output-price inflation. In this case we show that, even if determinacy is achieved, large spillovers may occur between countries. Author Affiliation: (a) Department of Economics, University of Glasgow, Adam Smith Building, Glasgow G12 8RT, UK (b) Department of Economics, University of Oxford, Manor Road Building, Manor Road, Oxford, OX1 3UQ, UK Article History: Received 13 March 2006; Accepted 24 April 2009 Article Note: (footnote) [star] Financial support from the ESRC (Grant nos. L138251050 and RES-156-25-003) is gratefully acknowledged. We would like to thank the editor, Juergen von Hagen, two anonymous referees, Tanya Kirsanova, Alan Sutherland and participants at conferences at the Universities of Oxford and Warwick for helpful comments on an earlier draft of the paper.

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.euroecorev.2009.04.007 Byline: Kai Christoffel (a), Keith Kuester (b), Tobias Linzert (a) Abstract: In this paper, we explore the role of labor markets for monetary policy in the euro area in a New Keynesian model in which labor markets are characterized by search and matching frictions. We first investigate to which extent a more flexible labor market would alter the business cycle behavior and the transmission of monetary policy. We find that while a lower degree of wage rigidity makes monetary policy more effective, i.e. a monetary policy shock transmits faster onto inflation, the importance of other labor market rigidities for the transmission of shocks is rather limited. Second, having estimated the model by Bayesian techniques we analyze to which extent labor market shocks, such as disturbances in the vacancy posting process, shocks to the separation rate and variations in bargaining power are important determinants of business cycle fluctuations. Our results point primarily towards disturbances in the bargaining process as a significant contributor to inflation and output fluctuations. In sum, the paper supports current central bank practice which appears to put considerable effort into monitoring euro area wage dynamics and which appears to treat some of the other labor market information as less important for monetary policy. Author Affiliation: (a) European Central Bank, KaiserstraAe 29, 60311 Frankfurt, Germany (b) Federal Reserve Bank of Philadelphia, Ten Independence Mall, Philadelphia, PA 19106, USA Article History: Received 5 April 2006; Accepted 24 April 2009

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.euroecorev.2009.04.013 Byline: Mathias Hoffmann (a), Ronald MacDonald (b) Abstract: Although the real exchange rate-real interest rate (RERI) relationship is central to most open economy macroeconomic models, empirical support for the relationship is generally found to be rather weak. In this paper we re-investigate the RERI relationship using bilateral US real exchange rate data spanning the period 1978-2007. Instead of testing one particular model, we build on Campbell and Shiller [1987. Cointegration tests of present-value models. Journal of Political Economy 95, 1062-1088] to propose a metric of the economic significance of the relationship. Our empirical results provide robust evidence that the RERI link is economically significant and that the real interest rate differential is a reasonable approximation of the expected rate of depreciation over longer horizons. Author Affiliation: (a) University of Zurich, Institute for Empirical Research in Economics, Zuerichbergstrasse 14, CH-8032 Zurich, Switzerland (b) Department of Economics, University of Glasgow, Glasgow G12 8RT, UK Article History: Received 12 September 2006; Accepted 24 April 2009 Article Note: (footnote) [star] The authors are grateful to the editor, Jurgen von Hagen, and to two anonymous referees for their helpful comments on an earlier draft of this paper. Hoffmann's research on this paper is part of the project The International Allocation of Risk funded by Deutsche Forschungsgemeinschaft in the framework of SFB 475 and of the MacroFinance project in the framework of University of Zurich's research priority program in Finance and Financial Markets.

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.euroecorev.2009.03.005 Byline: Harald Badinger (a)(b) Keywords: Globalization; Trade; Financial Openness; Inflation Abstract: This paper provides comprehensive evidence on the relation between inflation and globalization, defined here as trade and financial openness, using a large cross-section of 91 countries over the period 1985-2004. We establish two main empirical regularities: both higher trade and financial openness (i) reduce central banks' inflation bias, yielding lower average inflation and (ii) are associated with a larger output-inflation tradeoff. This evidence is at odds with the standard Barro-Gordon framework, which would require globalization to have a negative effect on the output-inflation tradeoff to yield lower equilibrium inflation, but it is consistent with a recent strand of new Keynesian models emphasizing the role of imperfect competition and nominal rigidities. Our findings also support the relevance of the time-inconsistency hypothesis, which underlies the theoretical models predicting a relation between globalization and inflation. For the OECD subsample, however, we do not find an effect of openness on inflation (the output-inflation tradeoff), suggesting that these countries have created an institutional framework for central banks that eliminates distortions due to the time-inconsistency problem. Author Affiliation: (a) Europainstitut, Department of Economics, Wirtschaftsuniversitat Wien, Vienna, Austria (b) Center for Economic Studies (CES), University of Munich, Munich, Germany Article History: Received 28 February 2008; Accepted 11 March 2009 Article Note: (footnote) [star] This paper has benefited much from the comments of two anonymous referees. I also wish to thank the editor for a number of helpful comments.

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.euroecorev.2009.04.011 Byline: Roman Inderst Abstract: This paper poses the question of how a firm should optimally choose both its organization and its compensation in the pursuit of innovation. One key result is that incentive pay arises as a robust instrument of innovation management both with and without delegation, although in the present model its primary purpose is not to elicit more effort for the creation of new ideas, but to ensure that new ideas are implemented if and only if this is efficient. While without delegation, the firm may 'underinvest' in innovation, with delegation the opposite bias may arise as new ideas may be implemented too often ('overinvestment'). The optimal organizational choice trades off these two biases. Author Affiliation: University of Frankfurt and LSE, Germany Article History: Received 31 October 2007; Accepted 28 April 2009 Article Note: (footnote) [star] This paper is a fully revised version of an earlier draft entitled 'Incentives to Generate and Implement New Ideas,' which focused on the design of the incentive scheme only.

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.euroecorev.2008.10.003 Byline: Prakash Kannan Abstract: Is it beneficial for a country's currency to be used internationally? And, if so, can we quantify the benefit? Since the emergence of the euro, there has been great interest in the consequences of a transfer of the dollar's premier international role to the euro. This paper presents a novel model-based approach towards assessing the welfare benefits associated with the international use of a country's currency. Apart from the familiar benefits associated with seigniorage, residents of the issuing country experience an increase in the purchasing power of their currency both at home and abroad. In the calibration exercise carried out in this paper, we find the benefits of an international currency to be quantitatively significant. The welfare gain for the Euro area in having the euro internationally used ranges from 1.9% to 2.3% of consumption depending on relative inflation rates. The rest of the world is not indifferent as to which currency circulates as the dominant international currency. Conditional on their currency not being used internationally, their preference is for the dominant international currency to be the one with the lowest inflation rate. Author Affiliation: Research Department, International Monetary Fund, 700 19th Street, NW, Washington, DC 20431, USA Article History: Received 10 August 2007; Accepted 21 October 2008

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.euroecorev.2008.09.001 Byline: Guo Ying Luo Abstract: This paper shows that a monopolistically competitive equilibrium can evolve without purposive profit maximization. Specifically, this paper formulates a precise evolutionary dynamic model of an industry where there is continuous entry of firms that randomly select their output levels on entry and fix their output levels thereafter. Firms exit the industry if they fail to pass the survival test of making nonnegative wealth. This paper shows that the industry converges in probability to the monopolistically competitive equilibrium as the size of each firm becomes infinitesimally small relative to the market, as the entry cost becomes sufficiently small, and as time gets sufficiently large. Consequently, in the limit, the only surviving firms are those producing at the tangency of the demand curve to the average cost curve and no potential entrant can make a positive profit by entry. Author Affiliation: Department of Finance and Business Economics, DeGroote School of Business, McMaster University, 1280 Main Street West, Hamilton, Ontario, Canada L8S 4M4 Article History: Received 17 January 2006; Accepted 4 September 2008 Article Note: (footnote) [star] I gratefully acknowledge the editor's and two anonymous referees' comments and suggestions. In addition, I thank Dean Mountain for his valuable comments and suggestions.

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.euroecorev.2008.09.003 Byline: Hans-Theo Normann Abstract: This paper analyzes the impact vertical integration has on upstream collusion when the price of the input is linear. As a first step, the paper derives the collusive equilibrium that requires the lowest discount factor in the infinitely repeated game when one firm is vertically integrated. It turns out this is the joint-profit maximum of the colluding firms. The discount factor needed to sustain this equilibrium is then shown to be unambiguously lower than the one needed for collusion in the separated industry. While the previous literature has found it difficult to reconcile raising-rivals'-costs strategies following a vertical merger with equilibrium behavior in the static game, they are subgame perfect in the repeated game studied here. Author Affiliation: Max Planck Institute for Research on Collective Goods, Bonn, Germany Article History: Received 28 January 2005; Accepted 4 September 2008

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.euroecorev.2008.07.003 Byline: Silvia Ardagna Abstract: Using a panel of OECD countries from 1960 to 2002, this paper shows that interest rates, particularly those of long-term government bonds, decrease when countries' fiscal position improves and increase around periods of budget deteriorations. Stock market prices surge around times of substantial fiscal tightening and plunge in periods of very loose fiscal policy. In addition, the paper shows that results depend on countries' initial fiscal conditions and on the type of fiscal consolidations: Fiscal adjustments that occur in country-years with high levels of government deficit, that are implemented by cutting government spending, and that generate a permanent and substantial decrease in government debt are associated with larger reductions in interest rates and increases in stock market prices. Author Affiliation: Department of Economics, Littauer Center, Harvard University, Cambridge, MA 02138, USA Article History: Received 6 February 2005; Accepted 27 July 2008

How inflation and unemployment are related in both the short run and long run is perhaps the key question in macroeconomics. This paper tests various price equations using quarterly U.S. data from 1952 to the present. Issues treated are the following. (1) Estimating price and wage equations in which wages affect prices and vice versa versus estimating 'reduced-form' price equations with no wage explanatory variables. (2) Estimating price equations in (log) level terms, first difference (i.e., inflation) terms, and second difference (i.e., change in inflation) terms. (3) The treatment of expectations. (4) The choice and functional form of the demand variable. (5) The choice of the cost-shock variable. The results suggest that the best specification is a price equation in level terms imbedded in a price-wage model, where the wage equation is also in level terms. The best cost-shock variable is the import price deflator, and the best demand variable is the unemployment rate. There is some evidence of a nonlinear effect of the unemployment rate on the price level at low values of the unemployment rate. Many of the results in this paper are contrary to common views in the literature, but the empirical support for them is strong. Keywords: Price equations NAIRU

Owing to dissatisfaction with the IMF's de jure classification of exchange-rate regimes, a substantial literature has emerged presenting de facto classifications of exchange-rate systems and using the latter classifications to compare performances of alternative regimes in terms of key macroeconomic variables. This paper critically reviews the literature on de facto regimes. In particular, the paper (1) describes the main methodologies that have been used to construct de facto codings, (2) surveys the empirical literature generated by de facto regime codings, and (3) lays-out the problems inherent in constructing de facto classifications. The empirical literature is found to yield few robust findings. We argue that the as-yet unfulfilled objective of this literature, and the major research agenda for the future in this area, lies in the need of a more thorough investigation of the degree of monetary-policy independence without relying exclusively on movements in exchange rates, an agenda the attainment of which is made especially challenging because of the lack of comprehensive and reliable data on reserves and interest rates. JEL classification: F3 Keywords: Exchange-rate regimes Economic growth Inflation Bipolar hypothesis

In a recent paper Hong and Shum [2006. Using price distributions to estimate search costs. Rand Journal of Economics 37, 257-275] present a structural method to estimate search cost distributions. We extend their approach to the case of oligopoly and present a new maximum likelihood method to estimate search costs. We apply our method to a data set of online prices for different computer memory chips. The estimates suggest that the consumer population can be roughly split into two groups which either have quite high or quite low search costs. Search frictions confer a significant amount of market power to the firms: Despite more than 20 firms operating in each of the markets, we estimate price-cost margins to be around 25%. The paper also illustrates how the structural method can be employed to simulate the effects of the introduction of a sales tax. JEL classification: C14; D43; D83; L13 Keywords: Consumer search; Oligopoly; Price dispersion; Structural estimation; Maximum likelihood

Council Regulation (EC) 1/2003 came into force in May 2004 and replaced the mandatory notification of agreements by a regime of ex post monitoring. This paper shows that ex post monitoring is the optimal audit regime when the competition authority's probability of error is low. On the other hand, the notification system becomes optimal when the competition authority's probability of error is high. The paper also shows that block exemptions and black list (regimes of per se (il)legality) should be implemented when the agreements' expected welfare impact is very high and very low, respectively. JEL classification: L4; D8 Keywords: Competition policy; Imperfect audit

There are a number of theoretical reasons why foreign direct investment (FDI) into a host country may depend on the FDI in proximate countries. Such spatial interdependence has been largely ignored by the empirical FDI literature, with only a couple recent papers accounting for such issues in their estimation. This paper conducts a general examination of spatial interactions in empirical FDI models using data on US outbound FDI activity. We find that estimated relationships of traditional determinants of FDI are surprisingly robust to inclusion of terms to capture spatial interdependence, even though such interdependence is estimated to be significant. However, we find that both the traditional determinants of FDI and the estimated spatial interdependence are quite sensitive to the sample of countries one examines. JEL classification: F21; F23. Keywords: Foreign direct investment; Multinational enterprises; Spatial econometrics

It is generally assumed that distance in the gravity model strictly reflects frictions impeding bilateral trade. However, distances North-South could also reflect differences in factor endowment that provide opportunities for profitable trade. This paper investigates the hypothesis that if we control for distance in the ordinary sense, differences North-South promote international trade. The hypothesis receives ample support. Moreover, the significance of differences North-South survives a battery of robustness tests, concerning period, distinctions between differences in latitude North-North, North-South and South-South, and controls for other measures of differences in factor endowment, such as differences in per capita output and differences in average temperature, rainfall, and seasonal range in temperature. The impact of differences North-South on bilateral trade has also been falling. This decline, in turn, might be partly responsible for the weakening of the influence of distance that has been occurring since World War II. This last hypothesis receives confirmation as well. Finally, the paper examines the impact of internal distance and remoteness on trade. Since both variables are country-specific, this is done by studying their impact on the country fixed effects themselves in the earlier estimates. Internal distance turns out to have a far greater impact than remoteness--by an order of 10. JEL classification: F10; F33 Keywords: Gravity; Bilateral trade; Distance; Remoteness; Comparative advantage; North South trade

This paper studies the effects of trade liberalization in the presence of consumption network externalities. The framework is applicable to the choice of network products and sheds light on the debate on globalization and culture. In an extended Ricardian model of international trade the paper shows that: (i) trade is not Pareto inferior to autarky if the free trade equilibrium is unique; (ii) trade is not Pareto superior to autarky if both countries are diverse (network competition) under free trade, but can be if each country is homogenous (network monopoly); (iii) and when multiple free trade equilibria exist everybody in a country can lose from free trade if that country is homogenous under autarky. Consumers of imported network goods tend to gain, while consumers of exported network goods tend to lose from trade liberalization. JEL classification: F02; F13; F14 Keywords: Gains from trade; Networks; Consumption externality; Culture; Globalization

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.euroecorev.2006.03.006 Byline: Charles Bellemare, Sabine Kroger Abstract: This paper analyzes the behavior of subjects randomly drawn from the Dutch population who reveal their capacity to provide and sustain social capital by their propensity to invest and reward investments in an economic experiment. We find that heterogeneity in behavior is characterized by several asymmetries -- men, the young and elderly, and low educated individuals invest relatively less, but reward significantly more investments. The age effects are found to corroborate existing findings, whereas those of gender and education do not. Higher expected levels of investments by others are found to have a positive and significant effect on own investments. Finally, a laboratory experiment with student subjects is found to provide a lower bound of the population level of social capital. Author Affiliation: Departement d'economique, Universite Laval, Canada Article History: Received 8 April 2006; Accepted 13 March 2006 Article Note: (footnote) [star] A previous version of this paper circulated under the title 'On Representative Trust'. Financial support from CentER and CentERdata is gratefully acknowledged.

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.euroecorev.2005.11.008 Byline: Antonio R. Antunes (a), Tiago V. de V. Cavalcanti (b) Abstract: This paper examines how much of the difference in the size of the informal sector and in per capita income across countries can be accounted by regulation costs and enforcement of financial contracts. It constructs and solves numerically a general equilibrium model with credit constrained heterogenous agents, occupational choices over formal and informal businesses, financial frictions and a government sector which imposes taxes and regulations on formal firms. The benefit from formalization is better access to outside finance. The quantitative exercises suggest that: (i) regulation costs and not the level of enforcement account for differences in the size of the informal sector between United States and Mediterranean Europe; (ii) for a developing country like Peru, however, contract enforcement and regulation costs are equally important in accounting for the size of the informal sector; and (iii) regulation costs and contract enforcement do not account for most of the income differences observed among countries. Author Affiliation: (a) Banco de Portugal, Departamento de Estudos Economicos, and Faculdade de Economia,Universidade Nova de Lisboa, Portugal (b) Departamento de Economia, Universidade Federal de Pernambuco, and INOVA, Faculdade de Economia, Universidade Nova de Lisboa, Portugal Article History: Received 5 June 2003; Accepted 21 November 2005 Article Note: (footnote) [star] Earlier versions of this paper circulated under the title 'Accounting for the Hidden Economy: Barriers to Legality and Legal Failures'.

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.euroecorev.2005.08.003 Byline: David Cook (a), Michael B. Devereux (b) Keywords: Capital inflows; Fiscal policy; Exchange rate regime; Pre-commitment Abstract: Many writers have argued for the benefits of a credible fixed exchange rate (a hard peg) as a commitment device in an open economy. But historically, fixed exchange rates have often been associated with large current account deficits and episodes of 'over-borrowing'. This paper develops a model of capital inflows that are linked to the exchange rate regime because of endogenous fiscal policy. The key message of the paper is that a hard peg is undesirable in the absence of commitment in fiscal policy. In face of a credible fixed exchange rate, the fiscal authority subsidizes capital inflows. The economy will engage in inefficiently high international borrowing, and in welfare terms may end up worse off than under capital market autarky. To eliminate the incentive to subsidize borrowing, the monetary authority must follow a flexible exchange rate rule in which capital inflows lead to exchange rate appreciation. If fiscal policy must be financed by money creation rather than direct taxation, then a fixed exchange rate rule may cause both over-borrowing and a subsequent exchange rate crisis. Author Affiliation: (a) Hong Kong University of Science and Technology, Hong Kong (b) University of British Columbia, CEPR, Canada Article History: Received 24 February 2004; Accepted 18 August 2005

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.euroecorev.2005.09.001 Byline: Joep Sonnemans Keywords: Behavioral finance; Natural experiment; Price clustering Abstract: This paper focuses on the tendency of stock prices to cluster at round numbers (like 10, 20, 30, etc. and to a lesser extent 5, 15, 25, etc.) and the related effect of round number price barriers (prices pass round numbers less frequently than other numbers). Two competing hypotheses are tested, using data from the Dutch stock market of the period 1990-2001. After 1 January 1999 stock prices were listed in euros, while guilders were still the currency of daily life until 2002. The aspiration level hypothesis predicts that round number effects in guilders will only slowly disappear. The odd price hypothesis predicts an abrupt change in round number effects after 1 January 1999. Generally, the results are consistent with the odd price hypothesis. Author Affiliation: Faculty of Economics and Econometrics, CREED, Roetersstraat 11, 1018 WB Amsterdam, The Netherlands Article History: Received 29 April 2004; Accepted 8 September 2005 Article Note: (footnote) [star] An earlier version of this paper was presented at the IAREP 2002 conference in Turku, Finland. The appendix is downloadable from http://www.fee.uva.nl/creed/people/sonnemans/index.shtml

Many writers have argued for the benefits of a credible fixed exchange rate (a hard peg) as a commitment device in an open economy. But historically, fixed exchange rates have often been associated with large current account deficits and episodes of 'over-borrowing'. This paper develops a model of capital inflows that are linked to the exchange rate regime because of endogenous fiscal policy. The key message of the paper is that a hard peg is undesirable in the absence of commitment in fiscal policy. In face of a credible fixed exchange rate, the fiscal authority subsidizes capital inflows. The economy will engage in inefficiently high international borrowing, and in welfare terms may end up worse off than under capital market autarky. To eliminate the incentive to subsidize borrowing, the monetary authority must follow a flexible exchange rate rule in which capital inflows lead to exchange rate appreciation. If fiscal policy must be financed by money creation rather than direct taxation, then a fixed exchange rate rule may cause both over-borrowing and a subsequent exchange rate crisis. JEL classification: F320; F400; F410 Keywords: Capital inflows; Fiscal policy: Exchange rate regime; Pre-commitment

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.euroecorev.2005.08.005 Byline: Arijit Mukherjee (a)(b), Enrico Pennings (c)(d) Keywords: Licensing; Tariff protection; Market structure Abstract: This paper challenges the conventional wisdom that exclusive owners of an advanced technology are always better off when producing as a monopolist than when competing against another firm. Competition against a less-efficient firm weakens the power that a host country can exert on the incumbent in the form of its tariff policy. We show that this gives a motive for a monopolist to license its technology to another foreign firm. A host country gains more from increased competition if it can induce the foreign incumbent to transfer technology to the host country firm. We show that the host country can do so by tariff commitment. We also discuss the implications of bargaining under licensing and Bertrand competition in the product market. Hence, this paper qualifies and extends the recent work of Kabiraj and Marjit [Protecting consumers through protection: The role of tariff-induced technology transfer. European Economic Review 47, 113-124]. Author Affiliation: (a) School of Economics, University of Nottingham, University Park, Nottingham, NG7 2RD, UK (b) The Leverhulme Centre for Research in Globalisation and Economic Policy, University Park, Nottingham, NG7 2RD, UK (c) Erasmus University, Rotterdam, The Netherlands (d) Tinbergen Institute, The Netherlands Article History: Received 16 March 2004; Accepted 2 August 2005

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.euroecorev.2005.05.001 Byline: Aleksander Berentsen Abstract: This paper considers whether fiat money can be provided by a revenue-maximizing monopolist in an environment where money is essential. Two questions arise concerning the private supply of money: Is it feasible and is it optimal? Concerning the feasibility question, I show that the revenue-maximizing policy is time-consistent if the trading history of the issuer is public information and if money demanders respond to the revelation of defection by playing autarky. Concerning the optimality question, the model suggests that any private organization of the market for fiat currency is suboptimal. Author Affiliation: Economics Department, University of Basel, Basel, Switzerland Article History: Received 21 December 2004; Accepted 8 May 2005 Article Note: (footnote) [star] An early version of the paper has circulated under the title 'Time-Consistent Private Supply of Outside Paper Money'.

This paper challenges the conventional wisdom that exclusive owners of an advanced technology are always better off when producing as a monopolist than when competing against another firm. Competition against a less-efficient firm weakens the power that a host country can exert on the incumbent in the form of its tariff policy. We show that this gives a motive for a monopolist to license its technology to another foreign firm. A host country gains more from increased competition if it can induce the foreign incumbent to transfer technology to the host country firm. We show that the host country can do so by tariff commitment. We also discuss the implications of bargaining under licensing and Bertrand competition in the product market. Hence, this paper qualifies and extends the recent work of Kabiraj and Marjit [Protecting consumers through protection: The role of tariff-induced technology transfer. European Economic Review 47, 113-124]. JEL Classification: D43; F13; L13 Keywords: Licensing; Tariff protection; Market structure

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.euroecorev.2005.03.005 Byline: Javier Andres, Rafael Domenech Abstract: This paper analyzes the effect of the fiscal structure upon the trade-off between inflation and output stabilization induced by technological shocks in a DGE model with nominal and real rigidities that also integrates a rich menu of fiscal variables as well as a target on the debt to output ratio. The channels through which fiscal policy affects macroeconomic stability include supply-side effects of distortionary taxes, the procyclical behavior of public spending induced by fiscal rules and the conventional effect of automatic stabilizers operating through disposable (permanent) income. The paper investigates these channels and concludes that, contrary to what has been found in RBC models, distortionary taxes tend to reduce output volatility relative to lump-sum taxes when significant rigidities are present. We also study the stabilization effect of alternative (distortionary) tax structures and find that these are only relevant if substantial rigidities are present. Author Affiliation: Analisis Economico, Universidad de Valencia, 46022 Valencia, Spain Article History: Received 23 February 2004; Accepted 10 March 2005

This paper analyzes the effect of the fiscal structure upon the trade-off between inflation and output stabilization induced by technological shocks in a DGE model with nominal and real rigidities that also integrates a rich menu of fiscal variables as well as a target on the debt to output ratio. The channels through which fiscal policy affects macroeconomic stability include supply-side effects of distortionary taxes, the procyclical behavior of public spending induced by fiscal rules and the conventional effect of automatic stabilizers operating through disposable (permanent) income. The paper investigates these channels and concludes that, contrary to what has been found in RBC models, distortionary taxes tend to reduce output volatility relative to lump-sum taxes when significant rigidities are present. We also study the stabilization effect of alternative (distortionary) tax structures and find that these are only relevant if substantial rigidities are present. JEL classification: E32; E52; E63 Keywords: Fiscal rules; Macroeconomic stability; Distortionary taxes

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.euroecorev.2005.02.006 Byline: Paul Cavelaars (a)(b) Abstract: This paper studies the output and price effects of exogenous changes in the degree of competition. It is motivated by initiatives to enhance competition in services in the European Union. The paper shows that a higher degree of competition in the nontradable goods sector may have adverse implications for international price competitiveness. It highlights four channels through which enhanced competition in the non-tradable goods sector affects output and the general price level in a large, open economy (lower monopoly rents, higher wages, lower import prices, international wealth transfer) and assesses their relative importance. The conclusions suggest that the Single Market enhances output and reduces the general price level. Author Affiliation: (a) Monetary and Economic Policy Department, De Nederlandsche Bank, Amsterdam, The Netherlands (b) Erasmus University Rotterdam, Rotterdam, The Netherlands Article History: Received 11 April 2003; Accepted 13 November 2005

This paper studies the output and price effects of exogenous changes in the degree of competition. It is motivated by initiatives to enhance competition in services in the European Union. The paper shows that a higher degree of competition in the nontradable goods sector may have adverse implications for international price competitiveness. It highlights four channels through which enhanced competition in the non-tradable goods sector affects output and the general price level in a large, open economy (lower monopoly rents, higher wages, lower import prices, international wealth transfer) and assesses their relative importance. The conclusions suggest that the Single Market enhances output and reduces the general price level. JEL classification: F150; F410. Keywords: Imperfect competition; Monetary policy; Liberalisation

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.euroecorev.2004.11.002 Byline: Dominique Demougin (a), Claude Fluet (b) Abstract: This paper investigates the incentive properties of the standard of proof for a finding of negligence when evidence about injurers' behavior is imperfect. We show that a 'more-likely-than-not' decision rule provides maximal incentives for potential tort-feasors to exert care. An injurer is then held liable whenever inadequate care appears more likely than due care, and not liable otherwise. Our analysis provides a deterrence rationale for the exclusionary rules of evidence found in common law and the preponderance of evidence standard of proof. Author Affiliation: (a) Humboldt Universitat zu Berlin, Spandauerstr. 1, 10178 Berlin, Germany (b) Universite du Quebec a Montreal, CIRPEE and CIRANO, CP 8888 succ. Centre-Ville, Montreal, Canada H3C 3P8 Article History: Received 28 April 2003; Accepted 12 November 2004 Article Note: (footnote) [star] This is an extensively reworked version of a paper presented at the 13th Maastricht Workshop in Law and Economics (April 2000) under the title 'Preponderance of evidence: tort rules and the efficient standard of proof'.

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.euroecorev.2006.02.005 Byline: Gregory Jolivet (a), Fabien Postel-Vinay (b)(c), Jean-Marc Robin (d)(e)(f) Abstract: Job search models of the labor market hypothesize a very tight correspondence between the determinants of labor turnover and individual wage dynamics on one hand, and the determinants of wage dispersion on the other. This paper offers a systematic examination of whether this correspondence is present in the data by estimating a rudimentary partial equilibrium job search model on a 3-year panel of individual worker data covering 10 European countries and the U.S. We find that our basic job search model fits the data surprisingly well. This also allows us to point at a number of interesting empirical regularities about wage distributions. Our results suggest that cross-sectional data on individual wages contain the basic information needed to obtain a reliable measure of the 'magnitude of labor market frictions', as measured by a parameter of the canonical job search model. Finally, we use our results in a cross-country comparison of the intensity and nature of job-to-job turnover. We arrange countries into two different groups according to their turnover intensity. We further show that the nature of job-to-job turnover is very different between those two groups: Turnover is predominantly voluntary in low-turnover countries, whereas it is to a large extent involuntary in high-turnover countries. Author Affiliation: (a) Universite de Paris I and CREST-INSEE, France (b) Department of Economics, University of Bristol, 8 Woodland Road, Bristol BS8 1TN, UK (c) PSE, and CREST-INSEE, France (d) Universite de Paris I, France (e) University College London, UK (f) Institute for Fiscal Studies, UK Article History: Received 29 September 2005; Accepted 22 February 2006 Article Note: (footnote) [star] A preliminary version of this paper was circulated under the title: 'Wage Distributions and Wage Dynamics in Europe and the U.S.: Lessons from a Simple Job Search Model'.

Does the search and matching model fit aggregate U.S. labor market data? While the model has become an important tool of macroeconomic analysis, recent literature pointed to some significant failures in accounting for the data. This paper aims to answer two questions: (i) Does the model fit the data, and, if so, on what dimensions? (ii) Does the data 'fit' the model, i.e. what are the data which are relevant to be explained by the model? The analysis shows that the model fits certain specifications of the data on many dimensions, though not on all. This includes capturing the high persistence and high volatility of most of the key variables, the negative co-variation of unemployment and vacancies, and the behavior of the worker job finding rate. A key role in this fit is played by the convexity of hiring costs and the stochastic properties of the separation rate. The latter is a major component of the rate discounting the future value of the job-worker match. The paper offers a workable, empirically grounded version of the model for the analysis of aggregate U.S. labor market dynamics. Keywords: Search; Matching; U.S. labor market; Vacancies; Labor market flows; Business cycles

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.euroecorev.2004.10.009 Byline: Pierre M. Picard (a)(b), Eric Toulemonde (c) Abstract: Economic geography models predict the agglomeration of manufacturing activies only if the workforce is mobile. Still, as the E.U.'s experience shows, core-periphery patterns exist even though the workforce is rather immobile. The paper provides a theoretical explanation for such core-periphery patterns through the effect that unions have on firms' incentive to agglomerate in a region. The paper offers fully analytical results about location equilibria and some interesting welfare properties. Author Affiliation: (a) School of Economic Studies, University of Manchester, Oxford Road, Manchester MP13 9PL, United Kingdom (b) CORE, Universite catholique de Louvain, Louvain-la-Neuve, Belgium (c) DEEP, HEC, Universite de Lausanne, BFSH1, CH-1015 Lausanne, Switzerland Article History: Received 28 February 2003; Accepted 20 October 2004

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.euroecorev.2005.01.003 Byline: Maarten C.W. Janssen Abstract: This paper develops an economic argument relating auctions to high market prices. At the core of the argument is the claim that market competition and bidding in an auction should be analyzed as part of one game, where the pricing strategies in the market subgame depend on the bidding strategies during the auction. I show that when there are two licenses for sale the only equilibrium in the overall game that is consistent with the logic of forward induction is the one where firms bid an amount (almost) equal to the profits of the cooperative market outcome and follow a cooperative pricing strategy in the market game resulting in high prices. With three or more licenses the auction format co-determines whether or not the forward induction argument works. Author Affiliation: Department of Economics, Erasmus University, H07-22, Postbox 1738, 3000 DR Rotterdam, The Netherlands Article History: Received 16 October 2003; Accepted 12 January 2005 Article Note: (footnote) [star] An earlier version of this paper was entitled Auctions as Collusion Devices. I thank Esther Gal-Or and two referees, Geir Asheim, Ken Binmore, Martin Dufwenberg, Paul Klemperer, Benny Moldovanu, Giancarlo Spagnolo, Elmar Wolfstetter and participants of presentations at ESEM 2003, Erasmus University and the AMD 2003 conference (Milan) for helpful comments.

Economic geography models predict the agglomeration of manufacturing activies only if the workforce is mobile. Still, as the E.U.'s experience shows, core-periphery patterns exist even though the workforce is rather immobile. The paper provides a theoretical explanation for such core--periphery patterns through the effect that unions have on firms' incentive to agglomerate in a region. The paper offers fully analytical results about location equilibria and some interesting welfare properties. Keywords: Agglomeration; Monopolistic competition; Unions

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.euroecorev.2004.07.004 Byline: T.S. Aidt (a), Jayasri Dutta (b), Elena Loukoianova (c) Abstract: This paper examines the relation between public spending and the spread of democracy in Western Europe during the period 1830-1938. Our data set includes measures of the size of the electorate, the election rule, and electoral participation, as well as measures of the size and composition of central government expenditures for 12 countries. We estimate panel regressions, and find that (1) the gradual lifting of socio-economic restrictions on the voting franchise contributed to growth in government spending mainly by increasing spending on infrastructure and internal security; (2) the female suffrage had a weak positive effect, through spending on health, education and welfare; (3) the change from majority to proportional rule, which took place in 10 of the countries, did not contribute to growth in government spending, and held back spending on health, education and welfare; (4) there exists (weak) complementarity between economic development and the spread of democracy. Author Affiliation: (a) Faculty of Economics, Jesus College, University of Cambridge, Austin Robinson Bldg., Sidgwick Ave., Cambridge CB3 9DD, UK (b) Department of Economics, University of Birmingham, Edgbaston B15 2TT, UK (c) The International Monetary Fund, 19 th Street, N.W., Washington, DC 20431, USA Article History: Received 15 July 2002; Accepted 30 July 2004 Article Note: (footnote) [star] The views expressed in this paper are those of the authors and do not necessarily represent those of the International Monetary Fund.

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.euroecorev.2004.09.001 Byline: Alistair Milne Abstract: This paper corrects a paper of David Miles, published in the European Economic Review in 1995, reversing some of the conclusions he draws. Solving his model correctly it turns out that, because depositors are unable to monitor the default risk of individual banks, moral hazard gives banks an incentive to increase risky lending. Prudential capital requirements reduce incentives to hold risky loans. Author Affiliation: Faculty of Finance, Cass Business School, City University, 106 Bunhill Row, London EC1Y 8TZ, UK Article History: Received 15 February 1999; Accepted 15 April 2004

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.euroecorev.2004.10.007 Byline: Sajid Anwar (a)(b), Robert McMillan (c), Mingli Zheng (d) Abstract: Much of the existing auction literature treats auctions as running independently of one another, with each bidder choosing to participate in only one auction. However, in many online auctions, a number of substitutable goods are auctioned concurrently and bidders can bid on several auctions at the same time. Recent theoretical research shows how bidders can gain from the existence of competing auctions, the current paper providing the first empirical evidence in support of competing auctions theory using online auctions data from eBay. Our results indicate that a significant proportion of bidders do bid across competing auctions and that bidders tend to submit bids on auctions with the lowest standing bid, as the theory predicts. The paper also shows that winning bidders who cross-bid pay lower prices on average than winning bidders who do not. Author Affiliation: (a) School of Business, James Cook University, P.O. Box 6811, Cairns, QLD 4870, Australia (b) IGSM University of South Australia, Adelaide, SA 5000, Australia (c) Department of Economics, University of Toronto, Toronto, Ontario M5S 3G7, Canada (d) Faculty of Social Sciences and Humanities, University of Macau, Taipa, Macau, China Article History: Received 25 February 2003; Accepted 4 October 2004 Article Note: (footnote) [star] This paper is based on Chapter 1 of Mingli Zheng's 2002 University of Toronto PhD thesis.

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.euroecorev.2004.07.006 Byline: Andreas Haufler (a), Ian Wooton (b)(c) Abstract: This paper analyses the effects of a regionally coordinated profit tax or location subsidy in a model with three active countries, one of which is not part of the union, and a globally mobile firm. We show that regional coordination can lead to two types of welfare gain. First, for investments that would take place in the union in the absence of coordination, a coordinated tax increase can transfer location rents from the firm to the union. Second, by internalising all of the union's benefits from foreign direct investment, a coordinated tax reduction can attract more welfare-enhancing investment than when member states act in isolation. Depending on which motive dominates, tax levels may thus rise or fall under regional coordination. Author Affiliation: (a) Seminar for Economic Policy, Department of Economics, University of Munich, Akademiestr. 1/II, 80799 Munich, Germany (b) Department of Economics, University of Strathclyde, Sir William Duncan Building, 130 Rottenrow, Glasgow G4 0GE, UK (c) CEPR, London, UK Article History: Received 8 July 2003; Accepted 8 July 2004 Article Note: (footnote) [star] Paper presented at conferences and workshops in Birmingham, Copenhagen, Crans-Montana, Dundee, Gottingen, Innsbruck, Linz, Milan Munchen, Namur and Toronto.

This paper corrects a paper of David Miles, published in the European Economic Review in 1995, reversing some of the conclusions he draws. Solving his model correctly it turns out that, because depositors are unable to monitor the default risk of individual banks, moral hazard gives banks an incentive to increase risky lending. Prudential capital requirements reduce incentives to hold risky loans. JEL classification: G28 Keywords: Bank regulation; Moral hazard

Much of the existing auction literature treats auctions as running independently of one another, with each bidder choosing to participate in only one auction. However, in many online auctions, a number of substitutable goods are auctioned concurrently and bidders can bid on several auctions at the same time. Recent theoretical research shows how bidders can gain from the existence of competing auctions, the current paper providing the first empirical evidence in support of competing auctions theory using online auctions data from eBay. Our results indicate that a significant proportion of bidders do bid across competing auctions and that bidders tend to submit bids on auctions with the lowest standing bid, as the theory predicts. The paper also shows that winning bidders who cross-bid pay lower prices on average than winning bidders who do not. JEL classification: D44; D440 Keywords: Competing auction; Cross-bidding; Auction empirics

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.euroecorev.2005.03.006 Byline: Robert Driskill Abstract: Multiple equilibria are a ubiquitous feature of dynamic rational expectations models. Researchers have been divided on the implications of this phenomenon. Some have viewed this as a reflection of reality and a possible explanation of a wide range of economic phenomena. Others have suggested various selection criteria for choosing one among the many equilibria. This paper reviews the major selection criteria that have been proposed, and through application to three well-known models shows under what circumstances one might expect them to choose the same or different equilibria. In addition, this paper proposes a new criteria based on the limit of finite-horizon equilibria and investigates its relation to the other criteria. Author Affiliation: Department of Economics, Vanderbilt University, Nashville, TN, USA Article History: Received 12 February 2004; Accepted 10 March 2005

Multiple equilibria are a ubiquitous feature of dynamic rational expectations models. Researchers have been divided on the implications of this phenomenon. Some have viewed this as a reflection of reality and a possible explanation of a wide range of economic phenomena. Others have suggested various selection criteria for choosing one among the many equilibria. This paper reviews the major selection criteria that have been proposed, and through application to three well-known models shows under what circumstances one might expect them to choose the same or different equilibria. In addition, this paper proposes a new criteria based on the limit of finite-horizon equilibria and investigates its relation to the other criteria. JEL classification: D840; E000 Keywords: Multiple equilibria; Rational expectations; Adaptive learning; Selection criteria; Indeterminacy; Minimal state variable

The purpose of this paper is to study the effects of tolling road use on a parallel road network where each link can be tolled by a different government. Using both theoretical and numerical models, the paper analyses the potential tax competition between countries that each maximise the surplus of local users plus tax revenues in controlling local and transit transport. Three types of tolling systems are considered: (i) toll discrimination between local traffic and transit, (ii) only uniform tolls on local and transit transport are acceptable, (iii) tolls on local users only. The results suggest that the welfare effects of introducing transit tolls are large, but that differentiation of tolls between local and transit transport as compared to uniform tolls does not yield large welfare differences. Also, the welfare effects of toll cooperation between countries are relatively small in comparison with the welfare gains of non-cooperative tolling of transit. The numerical model further illustrates the effects of different transit shares and explicitly considers the role of asymmetries between countries. Higher transit shares strongly raise the transit toll and slightly decrease local tolls. With asymmetric demands, the welfare gains of introducing differentiated tolling rise strongly for the country with lower local demand. JEL classification: H23; H71; R41; R48 Keywords. Congestion pricing; Transit traffic

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.euroecorev.2004.06.005 Byline: B. De Borger (a), S. Proost (b), K. Van Dender (c) Abstract: The purpose of this paper is to study the effects of tolling road use on a parallel road network where each link can be tolled by a different government. Using both theoretical and numerical models, the paper analyses the potential tax competition between countries that each maximise the surplus of local users plus tax revenues in controlling local and transit transport. Three types of tolling systems are considered: (i) toll discrimination between local traffic and transit, (ii) only uniform tolls on local and transit transport are acceptable, (iii) tolls on local users only. The results suggest that the welfare effects of introducing transit tolls are large, but that differentiation of tolls between local and transit transport as compared to uniform tolls does not yield large welfare differences. Also, the welfare effects of toll cooperation between countries are relatively small in comparison with the welfare gains of non-cooperative tolling of transit. The numerical model further illustrates the effects of different transit shares and explicitly considers the role of asymmetries between countries. Higher transit shares strongly raise the transit toll and slightly decrease local tolls. With asymmetric demands, the welfare gains of introducing differentiated tolling rise strongly for the country with lower local demand. Author Affiliation: (a) Department of Economics, University of Antwerp, Prinsstraat 13, B-2000 Antwerp, Belgium (b) Department of Economics, Catholic University of Leuven, Naamsestraat 69, B-3000 Leuven, Belgium (c) Department of Economics, University of California at Irvine, Irvine, CA 92697-5100, USA Article History: Received 8 September 2003; Accepted 23 June 2004

This paper calculates the quantitative significance of the welfare costs of union wage compression. This is done in a dynamic general equilibrium model with overlapping generations where agents choose both schooling (human capital) and assets (physical capital). The labor market in this model is characterized as a right-to-manage contract, which allows unions to compress wage differentials between high- and low-skilled workers, by implementing a binding minimum wage. This paper shows that when labor markets are competitive even low levels of wage compression lead to large welfare losses, since wage compression creates costly unemployment among low-skilled workers. The effect of wage compression on the supply of skilled labor, however, is rather small, since the disincentive effect of a lower, high-skilled wage is, to a large extent, offset by a lower opportunity cost of schooling due to higher unemployment. JEL classification: E24; J24; J31; J51 Keywords: Choice of schooling; Unemployment; Union wage compression; University wage premium; Welfare