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  4. December 2016
  5. Understanding the Gains from Wage Flexibility: The Exchange Rate Connection

Understanding the Gains from Wage Flexibility: The Exchange Rate Connection

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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 reductions as a means to stimulate employment is much smaller in a currency union, and (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.

Citation

Galí, Jordi, and Tommaso Monacelli. 2016. "Understanding the Gains from Wage Flexibility: The Exchange Rate Connection." American Economic Review, 106 (12): 3829-68. DOI: 10.1257/aer.20131658

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JEL Classification

  • E12 General Aggregative Models: Keynes; Keynesian; Post-Keynesian
  • E24 Employment; Unemployment; Wages; Intergenerational Income Distribution; Aggregate Human Capital; Aggregate Labor Productivity
  • E52 Monetary Policy
  • E63 Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy
  • F31 Foreign Exchange
  • F33 International Monetary Arrangements and Institutions
  • F41 Open Economy Macroeconomics