Understanding the gains from wage flexibility in a currency union: a fiscal policy connection

We investigate two findings in Gali and Monacelli (2016, American Economic Review): (i) the effectiveness of labor cost adjustments on employment is much smaller in a currency union and (ii) an increase in wage flexibility often reduces welfare, more likely in an economy that is part of a currency union. First, we introduce a distorted steady state into Gali and Monacelli’s small open economy model, in which employment subsidies making the steady state efficient are not available, and replicate their two findings. Second, an endogenous fiscal policy rule similar to that in Bohn (1998, Quarterly Journal of Economics) is introduced with a government budget constraint in the model. The results suggest that while Gali and Monacelli’s first finding is still applicable, their second finding is not necessarily valid. Therefore, an increase in wage flexibility may reduce welfare loss in an economy that is part of a currency union as long as wage rigidity is sufficiently high. Thus, there is scope to discuss how wage flexibility benefits currency unions.