Optimal Currency Areas with Labor Market Frictions

January 2019
Rohan Kekre

I study stabilization trade-offs and optimal monetary policy in a two-country monetary union with frictional labor markets. Given benchmark preferences and technologies, the constrained efficient allocation can be achieved if and only if productivity shocks affecting each country are symmetric, regardless of heterogeneity in labor market frictions across countries. When asymmetric shocks necessitate distortions in the union, optimal policy targets smaller inflation and output gaps in the more sclerotic labor market. Applied to the Eurozone, labor market frictions may not affect when the union will experience distortions but do imply welfare gains from redefining the inflation target of the ECB.

The working paper can be found here.

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