When an external asymmetric shock has an uneven impact in different regions of the union, the most affected countries, subject to a common monetary policy and under the limits of fiscal policy, have fewer options to respond to it.

The great recession and the crisis of sovereign debt can be described as asymmetric shocks for the euro zone, having affected the south of Europe far more than the countries of the north. 

The European Central Bank and other international organizations maintain that, in order to compensate for the negative effects of an adverse aggregate shock on employment and production, structural reforms are required, and, in particular, an increase in wage flexibility.

To the extent that wage flexibility acts as a substitute for exchange rate flexibility, this flexibility is seen as being particularly desirable in economies that have joined a monetary union.

The work by Jordi Galí, full professor of the Department of Economics and Business at UPF and director of the Research Centre for International Economics (CREI-UPF), and Tommaso Monacelli, professor of the Department of Economics at the University of Bocconi (Italy), upholds that the previous logic may be flawed, and that an increase in wage flexibility could even be harmful to social welfare in an economy that is part of a monetary union.

Two traditional mechanisms to stimulate the economy

In the article, published recently in the American Economic Review, the researchers get their results by using a model belonging to a small, open economy in an area within a monetary union. Traditionally, the reduction of wages is associated with improved production, demand and employment, through two mechanisms of transmission.

In the first mechanism, the competitiveness channel, lower wages lead to better terms of trade and greater competitiveness: domestic products replace foreign products, and this stimulates the aggregate demand and increases production, demand and employment.

The second mechanism, the endogenous policy channel, is more complex: a reduction in wages reduces inflation, and —in an economy with its own monetary policy— this generates a more expansive monetary policy, boosting aggregate demand and employment.

But, when a country cannot apply its own domestic monetary policy, as occurs in a monetary union, this second channel disappears and the effect of wage flexibility on employment and welfare can be null or even negative. The possible negative effect comes from the increase in the real interest rate generated by the foreseen decrease in expected inflation, without the latter being accompanied by a decrease in the interest rate in the case of a small country that belongs to a monetary union.

Wage flexibility and expansive fiscal policy

According to the authors, any reduction in salaries in response to an adverse shock should be complemented with policies capable of stimulating aggregate demand. In the case of a monetary union, only an expansive fiscal policy can achieve this goal.

The implication of this theory for the euro zone is that a coordinated European fiscal policy should allow countries affected by an asymmetric shock to be able to implement expansive fiscal policies, and thus flexibilize the restrictions imposed by the Maastricht Treaty.

Reference article: Jordi Galí, Tomasso Monacelli (2016).  “Understanding the Gains from Wage Flexibility: The Exchange Rate Connection” American Economic Review, 106 (12): 3829-68. DOI: 10.1257/aer.20131658