European labor markets and the Euro: How much flexibility do we really need?

Widespread concern over real effects of EMU is consistent with new Keynesian approaches to macroeconomic fluctuations, but more difficult to reconcile with a real business cycle (RBC) paradigm. Using a model with frictions as a point of departure, I argue that nominal price rigidity in Europe is likely to increase, while real rigidities are likely to decrease, as a consequence of monetary union. One curious consequence of this logic is a new European macroeconomic regime in which monetary policy is increasingly effective in influencing output in the short run. Similarly, changes in the nature of real and nominal price determination may increase the volatility of the European business cycle. Empirical evidence of increasing covariation of price inflation and declining correlation of wage inflation and real wage growth within EMU countries in the last decade is consistent with this conjecture. Calls for additional labor market flexibility, given the magnitude of what is already in store for Europe, may be unwarranted.