Understanding the Gains from Wage Flexibility: The Exchange Rate Connection

Jordi Galí, Tommaso Monacelli

NBER Working Paper No. 22489
Issued in August 2016
NBER Program(s):Economic Fluctuations and Growth, International Finance and Macroeconomics, Monetary Economics

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, (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.

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Document Object Identifier (DOI): 10.3386/w22489

Forthcoming in American Economic Review

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