This paper analyzes the degree of short-run, real wage flexibility in a two-sector economy under floating rates. This is done by deriving optimal wage indexation in a contracting framework. We find that the more closed the economy, the lower the degree of wage indexation. As a result, output will fluctuate less around its desired level in a more closed economy. These findings further imply that a given unexpected monetary shock will cause as maller output shock in a more open economy, whereas a given real shock will induce a smaller output shock in a more closed economy.

This paper outlines possible channels linking commercial and financial openness. This inquiry is motivated by a salient feature of the global economy in recent decades: the embrace, by developing countries, of financial reforms. The adjustment process to the growing financial integration has been rocky, frequently associated with financial crises. These developments have led to a spirited debate concerning the wisdom of unrestricted capital mobility between OECD and emerging-market countries. Various studies have identified circumstances in which unlimited capital mobility may be suboptimal. This paper argues that, notwithstanding the above debate, the strongest argument for financial opening may be the pragmatic one. Like it or not, greater trade integration erodes the effectiveness of restrictions on capital mobility. Hence, for successful emerging markets that engage in trade integration, financial opening is not a question of if, but of when and how. Some insight into the possible linkages between financial and trade opening is obtained by looking at the patterns of changes in openness in the last 30 years. In order to evaluate the statistical significance of the association between financial and trade openness, I apply a panelregression methodology. The units of observations are nonoverlapping five-year changes in the openness measures, throughout 1969–1998, for all countries (subject to data availability). Table 1 presents the regressions, where the dependent variable is the change in financial openness. The explanatory variables are changes in trade openness and changes in the level of GDP per capita, allowing for country fixed effects. Regression (i) reports all developing countries (subject to data availability), regression (ii) excludes from the sample developing-economies countries that are characterized by financial openness that exceeds 100 percent, or by trade openness that exceeds 60 percent, and small island economies. Finally, regression (iii) deals only with the OECD countries. The first two regressions indicate a highly significant positive association between changes in financial and commercial openness in developing countries. This effect in the OECD countries is positive, but at a substantially lower significance level. In Aizenman and Ilan Noy (2003), annual data are used to investigate the impact of political economy and other structural variables on the links between trade and financial openness. An extended version of our model, where political-economy considerations determine the efficiency of the tax system, suggests that democracies are associated with lower financial openness. Our empirical investigation, * 317 Social Sciences 1, Department of Economics, University of California–Santa Cruz, 1156 High St., Santa Cruz, CA 95064, and NBER (e-mail: [email protected]). I thank Shang-Jin Wei for sharing the data on financial openness, and Ilan Noy and Bill Koch for excellent research assistance. Useful comments by Mike Dooley, Michael Hutchison, Phil McCalman, Graciela Kaminsky, and Ken Kletzer are gratefully acknowledged. 1 A useful survey of financial liberalization is John Williamson and Molly Mahar (1998). See Carlos Diaz-Alejandro (1985), Dani Rodrik (1999), and Thomas Hellmann et al. (2000) for skeptical assessments of the gains from financial liberalization. For studies dealing with the financial instability associated with capital-account opening, see the papers in Sebastian Edwards and Jeffrey Frankel (2002). On the association between financial integration and financial crises see Asli Demirguc-Kunt and Enrica Detragiache (1998), Guillermo Calvo (1998), and Graciela Kaminsky and Carmen Reinhart (1999). 2 Financial openness measures (gross private capital inflows gross private outflows) 100/GDP, using the data documented and applied by Shang-Jin Wei and Yi Wu (2002), and Eswar Prasad et al. (2003). Trade openness measures (exports imports) 100/GDP, using the World Development Indicators (WDI) data. 3 The inclusion of GDP per capita as an explanatory variable is suggested by the linkages between GDP per capital level and financial depth. 4 Following the approach of Alex Cukierman et al. (1992), one expects less-polarized societies and better-functioning democracies to be characterized by more efficient taxcollection systems. Applying this conjecture, a more efficient tax system would be associated also with lower tax

This paper evaluates the impact of international reserves, terms-of-trade shocks, and capital flows on the real exchange rate (REER). We observe that international reserves cushion the impact of terms-of-trade shocks on REER, and that this effect is important for developing but not for industrial countries. This buffer effect is especially significant for Asian countries, and for countries exporting natural resources. Financial depth reduces the buffer role of international reserves in developing countries. Developing countries' REERs seem to be more sensitive to changes in reserve assets; whereas industrial countries display a significant relationship between hot money and REER.

This paper deals with the design of optimal monetary policy and with the interaction between the optimal degrees of wage indexation and foreign exchange intervention. The model is governed by the characteristics of the stochastic shocks which affect the economy and by the information set that individuals possess. Because of cost of negotiations, nominal wages are assumed to be precontracted and wage adjustments follow a simple indexation rule that links wage changes to observed changes in price. The use of the price level as the only indicator for wage adjustments may not permit an efficient use of available information and, may result in welfare loss. The analysis specifies the optimal set of feedback rules that should govern policy aiming at the minimization of the welfare loss. These feedback rules determine the optimal response of monetary policy to changes in exchange rates, interest rates and foreign prices. The adoption of the optimal set of feedback rules results in the complete elimination of the welfare cost arising from the simple indexation rule and from the existence of nominal contracts. Since optimal policies succeed in the elimination of the distortions, issues concerning the nature of contracts and the implications of specific assumptions about disequilibrium positions become inconsequential. The analysis then proceeds to examine the interdependence between the optimal feedback rules and the optimal degree of wage indexation. It is shown that a rise in the degree of exchange rate flexibility raises the optimal degree of wage indexation. One of the key conclusions is the proposition that the number of independent feedback rules that govern a policy must equal the number of independent sources of information that influence the determination of the undistorted equilibrium. Thus, it is shown that with a sufficient number of feedback rules for monetary policy there may be no need to introduce wage indexation. It is also shown that an economy that is not able to choose freely an exchange rate regime can still eliminate the welfare loss by supplementing the(constrained) monetary policy with an optimal rule for wage indexation. The paper concludes with an examination of the consequences of departures from optimal policy by comparing the welfare loss resulting from the imposition of alternative constraints on the degree of wage indexation, on foreign exchange intervention and on the magnitudes of other policy feedback coefficients.