Understanding the Gains from Wage Flexibility: The Exchange Rate Connection

• Authors: Jordi Galí and Tommaso Monacelli
• American Economic Review, Vol. 106, No. 12, 3829-3868, December 2016

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.