Paper #1408

Title:

Understanding the gains from wage flexibility: The exchange rate connection

Authors:

Jordi Galí and Tommaso Monacelli

Date:

December 2013 (Revised: June 2016)

Abstract:

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.

Keywords:

sticky wages, nominal rigidities, New Keynesian model, stabilization policies, exchange rate policy, currency unions, monetary policy rules.

JEL codes:

E32, E52, F41

Area of Research:

Macroeconomics and International Economics

Published in:

American Economic Review, 106 (12): 3829–3868, 2016

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