Inequality, Nominal Rigidities, and Aggregate Demand

This paper studies wage and price flexibility as a means of absorbing adverse shocks. We focus on economies with unequal access to financial markets and where the monetary authority is constrained by the zero lower bound. We show that the economy becomes more volatile in this setting when wages are more flexible. As our model assumes financial frictions, wage flexibility translates into output volatility via a redistribution channel, which operates through aggregate demand. We find that this volatility depends on the relative wage and price rigidity. Additionally, we show that the redistribution channel gains prominence when the central bank is at the zero lower bound. We conclude that in these kinds of economies, the usual recommendation of making labor markets more flexible to restore high output levels, is mistaken.