There across the member countries of a currency

There are two types
of labor market rigidities:

 Unemployment Rigidities (UR) and  Real Wage Rigidities (RWR).

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The former
capture institutions such as employment protection legislation, hiring costs
and the matching technology that limit the flows in and out of unemployment, while
the latter capture institutions that affect the responsiveness of real wages to
economic activity. The two types of labor market rigidities have various effects
on the willing for firms to reset prices and therefore on the Phillips curve. So
that, a higher level of unemployment rigidities makes the Phillips curve
steeper while real wage rigidities make the Phillips curve flatter. Intuition
is the following: when firms adjust prices rather than quantities in response
to the shocks, inflation becomes more sensitive.

Furthermore, labor
market rigidities have a powerful influence on the adjustment mechanism of

the currency
union to shocks. It is found that unemployment rigidities increase the
volatility

of the inflation
differential but decrease the volatility of the unemployment differential, whereas

real wage
rigidities raises the volatility of the unemployment differential and have
little

impact on the
volatility of the inflation differential. Asymmetries in unemployment and real

wage rigidities
across countries, however, increase the volatility of both inflation and un-

employment
differentials, mainly because different labor market institutions lead to
strong

asymmetric
responses to common shocks.

According to
Abbritti and Mueller (2012) the effects of the rigidities tend to offset each
other when they occur in complements, but they reinforce each other when they
are substitutes. This is an interesting result and further underlines the
importance of differentiating between different types of labor market
rigidities.

Overall, results
of Abbritti and Mueller (2012)  suggest
that asymmetries in labor market structures worsen the adjustment mechanism of
a currency union to symmetric and asymmetric shocks. Therefore, it may be
optimal to coordinate labor market reforms across the member countries of a currency
union and to limit the degree of asymmetry in labor market rigidities. Another important
consideration is that, in the presence of asymmetric labor market structures,

monetary policy
shocks themselves create terms of trade movements and are a source of

differentials.

 

Reference: Abritti 2012

 

Wage
Flexibility, Exchange Rate Policy and Welfare

One of the
determinants of the employment stability is the flexibility of wages and their
sensitivity to changes in economic conditions. Thus, there is a probability
that a decrease in the average wage against an adverse shock can at least
partly set apart the impact on employment.

However, with
regard to the findings of Gali and Monacelli (2013) exchange rate policy plays
a role in the stabilization of employment fluctuations in an open economy. Specifically,
when exchange rate stability has an essential weight in the monetary policy
strategy this role that is played by exchange rate policy is likely to be
limited.

Reference:
Gali 2013

 

Wage flexibility
can also result a decrease in welfare such that a decrease in demand due to
negative shocks will further raise the wage of employed people and at the
meantime unemployment level will rise.

However, it is
reasonable to point out that labor markets were more rigid in Europe and more
flexible in the USA. However, during 2001-2007 period,
a rise in labor market flexibility everywhere tended to decrease average
unemployment, whereas leaving unemployment relatively high in countries where
inequality is relatively low.

Giuseppe Bertola

Role
of Institutions

 

According to findings of Bassanini and Duval (2006) changes
in around two thirds of non-cyclical unemployment over the past two decades can
be explained by changes in policies and institutions. In particular, an
increase in aggregate unemployment is an outcome of high and long-lasting
unemployment benefits, high tax wedges and stringent anti-competitive product
market regulation (PMR). Estimations show that a 10 percentage point reduction
in the tax wedge, a 10 percentage point reduction of unemployment benefits
would be associated with a drop in the unemployment rate by about 2.8, 1.2
percentage points, respectively. On the contrary, some categories of public
spending on active labour market programmes (ALMPs), such as labour market
training, are estimated to be associated with lower unemployment.

Policies and institutions affect employment via their
impact on aggregate. High unemployment benefits and high tax wedges are found
to be associated with lower employment prospects for all groups.

The impact of any policy reform is
different and depends on the institutional context. Indeed, any reform
that lowers unemployment is likely to be complementary with all reforms
that go in the same direction. This suggests that well-designed reform packages
would yield greater employment gains than separate, “piece-meal” reforms,
although the magnitude of such reform complementarities is found to be moderate
for the average OECD country1.
                                 In spite
of systemic interactions, a few specific interactions seem to be particularly
robust: especially, the effect of generous unemployment benefits on
unemployment appears to be mitigated by high public spending on ALMPs. In
addition, in countries where binding minimum wage floors prevent tax shifting
to workers the unemployment effects of high tax wedges are found to be largest.

Tax incentives appear to play an
important role among the policies and institutions that affect the job
prospects of those groups “at the margin” of the labor market.

While
policies and institutions appear to play a major role in shaping employment
patterns, macroeconomic conditions also matter. Negative total factor
productivity shocks, deteriorations in the terms of trade, increases in
long-term real interest rates or negative labour demand shocks are all found to
increase aggregate unemployment. Furthermore, there is clear evidence that
their impact is shaped by existing policies and institutions. In particular,
the effects of macroeconomic shocks appear to be amplified by high unemployment
benefits and dampened by highly centralised and/or coordinated wage bargaining
systems. More tentatively, high rates of home ownership – which are often
associated with low degrees of labour mobility across regions – increase the
unemployment impact of shocks, while public spending on ALMPs reduce it. By
contrast, the effects of strict EPL or stringent PMR appear to be ambiguous.
They seem to dampen the unemployment effects of shocks in the short run, while
lengthening the adjustment period needed for unemployment to return to its
initial level2.

1
Determinants of Unemployment across OECD countries: Reassessing the role of
policies and institutions, Bassanini and Duval 2006

2
Determinants of Unemployment across OECD countries: Reassessing the role of
policies and institutions, Bassanini and Duval 2006

 

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