Understanding the Gains from Wage Flexibility: The Exchange Rate Connection

• Authors: Jordi Galí.
• BSE Working Paper: 110230 | September 15
• Keywords: sticky wages; nominal rigidities; new Keynesian model; stabilization policies; exchange rate policy; currency unions; monetary policy rules
• JEL codes: E32, E52, F41
• sticky wages; nominal rigidities; new Keynesian model; stabilization policies; exchange rate policy; currency unions; monetary policy rules

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.