Understanding the Gains from Wage Flexibility: The Exchange Rate Connection

We study the gains from increased wage flexibility and their dependence on exchange rate policy, using a small open economy model with staggered price and wage setting. Two results stand out: (i) the impact of wage adjustments on employment is smaller the more the central bank seeks to stabilize the exchange rate, and (ii) an increase in wage flexibility often reduces welfare, and more likely in economies under an exchange rate peg or an exchange rate-focused monetary policy. Our findings call into question the common view that wage flexibility is particularly desirable in a currency union.