Inequality, the Zero Lower Bound, and the Gains from Wage Flexibility

Abstract

This paper studies wage flexibility as a means to absorb adverse shocks. We focus on economies with unequal access to financial markets and where the monetary authority is constrained by the zero lower bound. We show that in this particular setting the economy can become more volatile when wages are more flexible. In the model, due to financial frictions, wage flexibility can translate into volatility in GDP because of a redistribution channel operating through aggregate demand. When the central bank is constrained by the zero lower bound this feature is exacerbated, making the zero lower bound more likely to bind and the crisis more severe. We conclude that in these kinds of economies, the usual recommendation of making labor markets more flexible to restore high output levels is misleading.