Understanding the Gains from Wage Flexibility: The Exchange Rate Connection Jordi Galí Tommaso Monacelli October 2013 Jordi Galí, Tommaso Monacelli () Wage Flexibility and the Exchange Rate October 2013 1 / 16
Gains from Wage Flexibility: The Conventional Wisdom Conventional wisdom (I): "Wage flexibility is a good thing" Jordi Galí, Tommaso Monacelli () Wage Flexibility and the Exchange Rate December 2013 2 / 16
Wage Flexibility and Employment Stability: The Classical View a. Wage flexibility b. Wage rigidity
Gains from Wage Flexibility: The Conventional Wisdom Conventional wisdom (I): "Wage flexibility is a good thing" Conventional wisdom (II): "Wage flexibility is a good thing. More so in a currency union" Jordi Galí, Tommaso Monacelli () Wage Flexibility and the Exchange Rate December 2013 3 / 16
Gains from Wage Flexibility: The Conventional Wisdom Conventional wisdom (I): "Wage flexibility is a good thing" Conventional wisdom (II): "Wage flexibility is a good thing. More so in a currency union" Recurrent calls for wage moderation and reforms to enhance wage flexibility, aimed at troubled euro are countries Jordi Galí, Tommaso Monacelli () Wage Flexibility and the Exchange Rate December 2013 4 / 16
Gains from Wage Flexibility Revisited: The Closed Economy Case (Galí, JEEA 2013) Closed economy model with staggered price and wage setting i t = ρ + φ π π t + φ y y t Taylor-type interest rate rule: Indirect effect of wages on employment: ↓ w ⇒ ↓ π ⇒ ↓ i ⇒ ↓ r ⇒ ↑ y ⇒ ↑ n ⇒ key role for endogenous monetary policy response Main finding : Increased wage flexibility may be welfare-reducing if φ π is small - limited effectiveness at stabilizing employment - costly "side effects" (increased volatility in wage and price inflation) Jordi Galí, Tommaso Monacelli () Wage Flexibility and the Exchange Rate December 2013 5 / 16
Gains from Wage Flexibility Revisited: The Closed Economy Case (Galí, JEEA 2013) Closed economy model with staggered price and wage setting i t = ρ + φ π π t + φ y y t Taylor-type interest rate rule: Indirect effect of wages on employment: ↓ w ⇒ ↓ π ⇒ ↓ i ⇒ ↓ r ⇒ ↑ y ⇒ ↑ n ⇒ key role for endogenous monetary policy response Main finding : Increased wage flexibility may be welfare-reducing if φ π is small - limited effectiveness at stabilizing employment - costly "side effects" (increased volatility in wage and price inflation) Caveat: closed economy, no room for "competitiveness channel" Jordi Galí, Tommaso Monacelli () Wage Flexibility and the Exchange Rate December 2013 6 / 16
Gains from Wage Flexibility Revisited: The Open Economy Framework: small open economy New Keynesian model GM 2005 + wage rigidities Transmission of wage changes to employment: - "endogenous policy channel" - "competitiveness channel" Questions: - Is increased wage flexibility always desirable? - More so in a currency union? - What is the role of the exchange rate policy/regime? The exchange rate connection : with a more rigid exchange rate, wage flexibility is... ⇒ more valuable to bring about warranted changes in terms of trade ⇒ less effective due to muted monetary policy response Jordi Galí, Tommaso Monacelli () Wage Flexibility and the Exchange Rate December 2013 7 / 16
Basic Framework Domestic households ∞ β t U ( C t , N t ; X t ) ∑ E 0 t = 0 � � η 1 1 − 1 1 1 − 1 η C H , t η + ν η C F , t η − 1 C t ≡ ( 1 − ν ) η � � 1 � ǫ p ǫ p − 1 ǫ p − 1 ǫ p dj C H , t ≡ 0 C H , t ( j ) � � 1 1 + ϕ N 1 + ϕ U ( C t , N t ; X t ) = log C t − X t t where x t ≡ log X t ∼ AR ( 1 ) ("demand shock") Assumption: access to (complete) international financial markets Jordi Galí, Tommaso Monacelli () Wage Flexibility and the Exchange Rate December 2013 8 / 16
Basic Framework Domestic firms Y t = A t N 1 − α t where a t ≡ log A t ∼ AR ( 1 ) ("technology shock") Monopolistic competition in goods and labor markets Staggered price and wage setting à la Calvo Producer currency pricing (full pass-through) Monetary policy φ e i t = φ π π H , t + e t 1 − φ e Limiting case: as φ e → 1, exchange rate peg ( e t = 0) Jordi Galí, Tommaso Monacelli () Wage Flexibility and the Exchange Rate December 2013 9 / 16
The Impact of Labor Costs on Employment: The Role of Exchange Rate Policy Exogenous payroll tax process τ t = ρ τ τ t − 1 + ε τ t Baseline calibration: - openness: ν = 0 . 4 - elasticity of substitution: η = 1 - nominal rigidities: θ p = θ w = 0 . 75 - inflation coefficient: φ π = 1 . 5 Response of employment to a 1 % payroll tax cut, as a function of φ e Jordi Galí, Tommaso Monacelli () Wage Flexibility and the Exchange Rate December 2013 10 / 16
Dynamic Response of Employment to a Payroll Tax Cut
The Impact of Labor Costs on Employment: Dissecting the Mechanism Labor demand 1 n t = 1 − α ( y t − a t ) Equilibrium output y t = ( 1 − ν ) c t + ην ( 2 − ν ) s t Equilibrium consumption: � � ∞ ∑ c t = x t − ( 1 − ν ) E t ( i t + k − E t { π H , t + 1 + k } ) k = 0 Equilibrium terms of trade: � � ∞ ∑ s t = − E t ( i t + k − E t { π H , t + 1 + k } ) k = 0 ⇒ key role for monetary policy response, shaped by exchange rate policy Jordi Galí, Tommaso Monacelli () Wage Flexibility and the Exchange Rate December 2013 11 / 16
Dynamic Responses to a Payroll Tax Cut: Interest Rates Nominal interest rate Real interest rate
Welfare Gains from Increased Wage Flexibility: The Exchange Rate Connection Interaction between: - wage stickiness: θ w ∈ [ 0 , 1 ] - exchange rate stability: φ e ∈ [ 0 , 1 ] Welfare loss in the unit-elasticity case ( η = 1) � � � ǫ w � ǫ p var ( π p var ( π w L ∼ ( 1 + ϕ ) var ( � n t ) + t ) + t ) λ p ( 1 − α ) λ w Conditional analysis: (i) demand shocks (ii) technology shocks Jordi Galí, Tommaso Monacelli () Wage Flexibility and the Exchange Rate December 2013 12 / 16
Wage Flexibility, Exchange Rate Policy and Welfare: Demand Shocks
Wage Flexibility, Exchange Rate Policy and Welfare: Demand Shocks Welfare Loss Components employment gap price inflation wage inflation
Welfare Impact Regions: Demand Shocks ∂ Welfare > 0 ∂ θ w ∂ Welfare < 0 ∂ θ w
Wage Flexibility, Exchange Rate Policy and Welfare: Technology Shocks
Wage Flexibility, Exchange Rate Policy and Welfare: Technology Shocks Welfare Loss Components employment gap price inflation wage inflation
Welfare Impact Regions: Technology Shocks ∂ Welfare > 0 ∂ θ w ∂ Welfare < 0 ∂ θ w
Welfare Gains from Increased Wage Flexibility: The Exchange Rate Connection Interaction between: - wage stickiness: θ w ∈ [ 0 , 1 ] - exchange rate stability: φ e ∈ [ 0 , 1 ] Welfare loss in the unit-elasticity case ( η = 1) � � � ǫ w � ǫ p var ( π p var ( π w L ∼ ( 1 + ϕ ) var ( � n t ) + t ) + t ) λ p ( 1 − α ) λ w Conditional analysis: (i) demand shocks (ii) technology shocks Robustness to alternative calibrations: - trade elasticity, η - openness, ν - price stickiness, θ p Jordi Galí, Tommaso Monacelli () Wage Flexibility and the Exchange Rate December 2013 13 / 16
Wage Flexibility, Exchange Rate Policy and Welfare: Demand Shocks The Case of a Non-Unitary Elasticity of Substitution Low Elasticity High Elasticity
Figure 5.a Welfare Impact of Enhanced Wage Flexibility: Demand Shocks The Role of Openness under a High Trade Elasticity ( η =2)
Figure 5.b Welfare Impact of Enhanced Wage Flexibility: Demand Shocks The Role of Openness under a Low Trade Elasticity ( η =0.5)
Welfare Impact of Enhanced Wage Flexibility: Demand Shocks The Role of Price Stickiness
Wage and Price Flexibility, Exchange Rate Policy and Welfare: Demand Shocks
Concluding remarks Conventional wisdom "Wage flexibility is a good thing. More so in a currency union" Jordi Galí, Tommaso Monacelli () Wage Flexibility and the Exchange Rate December 2013 14 / 16
Concluding remarks Conventional wisdom "Wage flexibility is a good thing. More so in a currency union" Finding #1: Effectiveness of labor cost adjustments on employment inversely related to exchange rate "rigidity" ⇒ least effective in a currency union Jordi Galí, Tommaso Monacelli () Wage Flexibility and the Exchange Rate December 2013 15 / 16
Concluding remarks Conventional wisdom "Wage flexibility is a good thing. More so in a currency union" Finding #1: Effectiveness of labor cost adjustments on employment inversely related to exchange rate "rigidity" ⇒ least effective in a currency union Finding #2 : Increased wage flexibility often welfare-reducing. ⇒ more likely so in a currency union . Jordi Galí, Tommaso Monacelli () Wage Flexibility and the Exchange Rate December 2013 16 / 16
Welfare Impact of Enhanced Wage Flexibility: Technology Shocks The Role of Price Stickiness
Wage and Price Flexibility, Exchange Rate Policy and Welfare: Technology Shocks
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