Asymmetric Labor Market Institutions in the EMU: positive and normative implications
How do labor market institutions affect the volatility and persistence of inflation and unemployment in a monetary union? What are the implications for monetary policy? This paper sets up a DSGE currency union model with unemployment, hiring frictions and real wage rigidities. The model provides a rigorous but tractable framework for the analysis of the functioning of a currency union characterized by asymmetric labor market institutions. Positively, we find that inflation and unemployment differentials depend strongly on the underlying labor market structure: the hiring friction lowers the persistence and increases the volatility of the inflation differential whereas real wage rigidities imply more persistence and variability in output and unemployment differentials. Normatively, we find that macroeconomic stabilization is easier when labor market frictions are high and real wage rigidities are low. This has important implications for optimal monetary policy: The optimal inflation target should give a higher weight to regions with more sclerotic labor markets and more flexible real wages.
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