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RETHINKING OPTIMAL EXCHANGE RATE REGIMES WITH FRICTIONAL LABOR MARKETS

Published online by Cambridge University Press:  31 January 2014

Alessia Campolmi  and
Ester Faia
Alessia Campolmi
Affiliation:
Central European University and Magyar Nemzeti Bank
Ester Faia*
Affiliation:
Goethe University Frankfurt and CFS
*
Address correspondence to: Ester Faia, Department of Money and Macro, Goethe University Frankfurt, House of Finance, office 3.47, Grueneburgplatz 1, 60323, Frankfurt am Main, Germany; e-mail: [email protected]. URL: www.wiwi.uni-frankfurt.de/profs/faia.
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Abstract

Currency fluctuations are an important determinant of labor market dynamics. Vice versa, relative labor costs affect real exchange rate dynamics. The optimal choice of exchange rate regimes cannot neglect this nexus. We assess such a choice using a two-country model with frictional labor markets. The monetary authority faces a tension between the classical insulating property of floating exchange rates and the destabilizing effects of currency fluctuations on (relative) job flows. Results show that the second motive is important: optimal monetary policy prescribes (some) response to the exchange rate. We also reexamine the conditions for optimal policy in a currency area whose members experience asymmetries in labor market institutions.

Keywords

Optimal Exchange Rate RegimesFrictional Labor MarketsWelfare
Type
Articles
Information
Macroeconomic Dynamics , Volume 19 , Issue 5 , July 2015 , pp. 1116 - 1147
Copyright
Copyright © Cambridge University Press 2014 

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