Faculty of Economics and Business Administration Publications Database

Rethinking Optimal Exchange Rate Regimes with Frictional Labour Market

Campolmi, Alessia
Volume: 19
Number: 5
Pages: 1116 - 1147
Month: July
ISSN-Print: 1365-1005
Link External Source: Online Version
Year: 2015
Keywords: Optimal Exchange Rate Regimes; Frictional Labor Markets; Welfare

Currency fluctuations are an important determinant of labor market dynamics. Vice versa, relative labor costs affect real exchange rate dynamics. The optimal choice of exchange rate regimes cannot neglect this nexus. We assess such a choice using a two-country model with frictional labor markets. The monetary authority faces a tension between the classical insulating property of floating exchange rates and the destabilizing effects of currency fluctuations on (relative) job flows. Results show that the second motive is important: optimal monetary policy prescribes (some) response to the exchange rate. We also reexamine the conditions for optimal policy in a currency area whose members experience asymmetries in labor market institutions.