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Welfare Implications of Heterogeneous Labor Markets in a Currency Area

This paper investigates the role of labor markets heterogeneity in a monetary union and especially what are the welfare gains/costs of labor market reforms for each member of the area. To this end, we develop a medium-scale two-country model representing a currency union characterized by price and wage stickiness, real rigidities and labor market frictions. We make various scenarios of labor market reform and seek to determine the direction in which a country has an incentive to direct it from a welfare perspective. We find that the choice of the instrument to direct a reform (aiming at reducing the home unemployment rate) has drastic welfare implications in the union. Reforming the domestic labor market by a stronger regulation seems to give the best output. The analysis also shows that labor markets heterogeneity has sizeable effects on the amount of welfare gains, following a reform. The more flexible the foreign labor market, the higher its welfare. Finally, a sensitivity analysis shows that (i) the way the monetary authorities conduct their policy has negligible welfare effects but (ii) the size of a country in the monetary union is far to be neutral.

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Paper provided by Banque de France in its series Working papers with number 199.

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Length: 37 pages
Date of creation: 2008
Date of revision:
Handle: RePEc:bfr:banfra:199
Contact details of provider: Postal: Banque de France 31 Rue Croix des Petits Champs LABOLOG - 49-1404 75049 PARIS
Web page: http://www.banque-france.fr/

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  1. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 2005. "Nominal Rigidities and the Dynamic Effects of a Shock to Monetary Policy," Journal of Political Economy, University of Chicago Press, vol. 113(1), pages 1-45, February.
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  11. Smets, F. & Sahuc, J-G., 2007. "Differences in Interest Rate Policy at the ECB and the Fed: An Investigation with a Medium-Scale DSGE Model," Working papers 182, Banque de France.
  12. Faia, Ester, 2008. "Optimal monetary policy rules with labor market frictions," Journal of Economic Dynamics and Control, Elsevier, vol. 32(5), pages 1600-1621, May.
  13. Antonella Trigari, 2006. "The Role of Search Frictions and Bargaining for Inflation Dynamics," Working Papers 304, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
  14. Smets, Frank & Wouters, Raf, 2004. "Comparing shocks and frictions in US and euro area business cycles: a Bayesian DSGE approach," Working Paper Series 0391, European Central Bank.
  15. Michael U. Krause & Thomas A. Lubik, 2010. "On-the-job search and the cyclical dynamics of the labor market," Working Paper 10-12, Federal Reserve Bank of Richmond.
  16. Carlos Thomas, 2006. "Search and matching frictions and optimal monetary policy," LSE Research Online Documents on Economics 19782, London School of Economics and Political Science, LSE Library.
  17. Stéphanie Guichard & Jean-Pierre Laffargue, 2000. "The Wage Curve: The Lessons of an Estimation Over a Panel of Countries," Working Papers 2000-21, CEPII research center.
  18. Krause, Michael U. & Lubik, Thomas A., 2007. "The (ir)relevance of real wage rigidity in the New Keynesian model with search frictions," Journal of Monetary Economics, Elsevier, vol. 54(3), pages 706-727, April.
  19. Gianluca Benigno & Pierpaolo Benigno, 2003. "Price Stability in Open Economies," Review of Economic Studies, Oxford University Press, vol. 70(4), pages 743-764.
  20. Arnaud Cheron & Francois Langot, 2004. "Labor Market Search and Real Business Cycles: Reconciling Nash Bargaining with the Real Wage Dynamics," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 7(2), pages 476-493, April.
  21. Olivier Blanchard & Jordi Gali, 2006. "A new Keynesian model with unemployment," Working Paper Research 92, National Bank of Belgium.
  22. Frank Smets & Raf Wouters, 2002. "An estimated dynamic stochastic general equilibrium model of the euro area," Working Paper Research 35, National Bank of Belgium.
  23. Robert E. Hall, 2005. "Employment Fluctuations with Equilibrium Wage Stickiness," American Economic Review, American Economic Association, vol. 95(1), pages 50-65, March.
  24. Barbara Petrongolo & Christopher Pissarides, 2000. "Looking into the black box: a survey of the matching function," LSE Research Online Documents on Economics 2122, London School of Economics and Political Science, LSE Library.
  25. Pau Rabanal & Juan Rubio-Ramírez, 2008. "Comparing new Keynesian models in the Euro area: a Bayesian approach," Spanish Economic Review, Springer, vol. 10(1), pages 23-40, March.
  26. Bodart, Vincent & De Walque, Gregory & Pierrard, Olivier & Sneessens, Henri R. & Wouters, Raf, 2006. "Nominal Wage Rigidities in a New Keynesian Model with Frictional Unemployment," IZA Discussion Papers 2528, Institute for the Study of Labor (IZA).
  27. Christoffel, Kai & Linzert, Tobias, 2006. "The role of real wage rigidity and labor market frictions for unemployment and inflation dynamics," Discussion Paper Series 1: Economic Studies 2006,11, Deutsche Bundesbank, Research Centre.
  28. Merz, Monika, 1995. "Search in the labor market and the real business cycle," Journal of Monetary Economics, Elsevier, vol. 36(2), pages 269-300, November.
  29. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  30. Moyen, Stephane & Sahuc, Jean-Guillaume, 2005. "Incorporating labour market frictions into an optimising-based monetary policy model," Economic Modelling, Elsevier, vol. 22(1), pages 159-186, January.
  31. Jordi Gal� & Tommaso Monacelli, 2005. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Review of Economic Studies, Oxford University Press, vol. 72(3), pages 707-734.
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