EMU: What if the Shocks are in the Labor Markets?

This paper argues that labor markets across Europe vary dramatically in their fundamentals features and rigidities across Europe. Thus, any discussion of an optimum currency area should focus on the differences and the idiosyncratic changes in the labor markets. After demonstrating the vast differences and changes in the labor markets across Europe, we construct a model with differential goods, monopolistic competition, free trade and labor market rigidities. We show that a change in labor market features in one country, such as a change in the unemployment benefits, affects the equilibrium unemployment and real wages in both countries. Independent monetary policy, i.e., having distinct currencies, can be used to control the speed of adjustment to the new equilibrium. An active monetary policy can speed the adjustment to an equilibrium with low unemployment following a positive change in the labor market.