Heterogeneity, Rigidity and Convergence of Labor Markets in the Euro Area

Abstract

This paper investigates the welfare consequences of labor market convergence reforms for a large range of calibrations in a two-country monetary union DSGE model with search and matching frictions. The model features trade in consumption and investment goods, price stickiness, firing costs and is calibrated to reflect the structural asymmetries of flexible and rigid countries of the Euro Area in terms of size and labor market variables. Across steady states, convergence brings welfare gains for the rigid country and welfare losses for the flexible country in most situations. The higher the flexibility induced by the convergence, the higher the gains for the rigid country and the lower the losses for the flexible country. Taking into account the transition path brings results that are qualitatively similar, but have a lower magnitude in terms of welfare gains/losses. Indeed, wage bargaining has a short-term negative impact on the rigid country and a short-term positive impact on the flexible country. As such, I conclude that convergence in labor markets can lead to substantial welfare gains in a monetary union, but only if the implementation is carefully designed.