Working Paper: CEPR ID: DP9133
Authors: Stephanie Schmitt-Grohé; Martín Uribe
Abstract: Since the onset of the great recession in peripheral Europe, nominal hourly wages have not fallen much from the high levels they had reached during the boom years in spite of widespread increases in unemployment. This observation evokes a well-known narrative in which nominal downward wage rigidity is at the center of the current unemployment problem. We embed downward nominal wage rigidity into a small open economy with tradable and nontradable goods and a fixed exchange-rate regime. In this model, negative external shocks cause involuntary unemployment. We analyze a number of national and supranational policy options for alleviating the unemployment problem caused by the combination of downward nominal wage rigidity and a fixed exchange-rate regime. We argue that, in spite of the existence of a battery of domestic policies that could be effective in solving the unemployment problem, it is unlikely that a solution will come from within national borders. This leaves supranational monetary stimulus as the most compelling avenue out of the crisis. Our model predicts that full employment in peripheral Europe could be restored by raising the Euro-area annual rate of inflation to about 4 percent for the next five years.
Keywords: currency pegs; downward wage rigidity; inflation; monetary union
JEL Codes: E31; E62; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| inflation policy (E64) | employment levels (J23) |
| downward nominal wage rigidity (J31) | unemployment (J64) |
| inflation (E31) | real value of wages (J31) |
| real value of wages (J31) | employment recovery (J68) |