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Understanding the Gains from Wage Flexibility: The Exchange Rate Connection

  • Jordi Galí
  • Tommaso Monacelli

We study the gains from increased wage flexibility using a small open economy model with staggered price and wage setting. Two results stand out: (i) the effectiveness of labor cost adjustments on employment is much smaller in a currency union, (ii) an increase in wage flexibility often reduces welfare, more likely so in an economy that is part of a currency union or with an exchange rate-focused monetary policy. Our findings call into question the common view that wage flexibility is particularly desirable in a currency union.

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Paper provided by Barcelona Graduate School of Economics in its series Working Papers with number 746.

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Date of creation: Aug 2015
Handle: RePEc:bge:wpaper:746
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  1. Jordi Galí & Tommaso Monacelli, 2003. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Working Papers 11, Barcelona Graduate School of Economics.
  2. Blanchard, Olivier J & Galí, Jordi, 2008. "Labour Markets and Monetary Policy: A New Keynesian Model with Unemployment," CEPR Discussion Papers 6765, C.E.P.R. Discussion Papers.
  3. Emi Nakamura & Jón Steinsson, 2008. "Five Facts about Prices: A Reevaluation of Menu Cost Models," The Quarterly Journal of Economics, Oxford University Press, vol. 123(4), pages 1415-1464.
  4. Martin Uribe & Stephanie Schmitt-Grohe, 2012. "Pegs and Pain," 2012 Meeting Papers 303, Society for Economic Dynamics.
  5. Gauti B. Eggertsson & Andrea Ferrero & Andrea Raffo, 2013. "Can structural reforms help Europe?," International Finance Discussion Papers 1092, Board of Governors of the Federal Reserve System (U.S.).
  6. Mongelli, Francesco Paolo, 2002. ""New" views on the optimum currency area theory: what is EMU telling us?," Working Paper Series 0138, European Central Bank.
  7. Bianca De Paoli, 2004. "Monetary Policy and Welfare in a Small Open Economy," CEP Discussion Papers dp0639, Centre for Economic Performance, LSE.
  8. Christopher J. Erceg & Jesper Lindé, 2012. "Fiscal consolidation in an open economy," International Finance Discussion Papers 1046, Board of Governors of the Federal Reserve System (U.S.).
  9. Alessandro Barattieri & Susanto Basu & Peter Gottschalk, 2010. "Some Evidence on the Importance of Sticky Wages," NBER Working Papers 16130, National Bureau of Economic Research, Inc.
  10. Stephanie Schmitt-Grohe & Martin Uribe, 2001. "Solving Dynamic General Equilibrium Models Using a Second-Order Approximation to the Policy Function," Departmental Working Papers 200106, Rutgers University, Department of Economics.
  11. Andrew Levin & Christopher J. Erceg & Dale W. Henderson, 1999. "Optimal Monetary Policy with Staggered Wage and Price Contracts," Computing in Economics and Finance 1999 1151, Society for Computational Economics.
  12. Tommaso Monacelli, 1999. "Into the Mussa Puzzle: Monetary Policy Regimes and the Real Exchange Rate in a Small Open Economy," Boston College Working Papers in Economics 437, Boston College Department of Economics, revised 15 Sep 2000.
  13. Robert Shimer, 2005. "The Cyclical Behavior of Equilibrium Unemployment and Vacancies," American Economic Review, American Economic Association, vol. 95(1), pages 25-49, March.
  14. Campolmi, Alessia, 2014. "Which Inflation To Target? A Small Open Economy With Sticky Wages," Macroeconomic Dynamics, Cambridge University Press, vol. 18(01), pages 145-174, January.
  15. Robert E. Hall, 2005. "Employment Fluctuations with Equilibrium Wage Stickiness," American Economic Review, American Economic Association, vol. 95(1), pages 50-65, March.
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