Exchange Rate Regimes and Wage Comovements in a Dynamic Ricardian Model

We construct a dynamic Ricardian model with a nominal exchange rate and trade costs. The model predicts that the nominal wages of the trading countries exhibit stronger positive comovements when the countries fix their bilateral exchange rates, while comovements of real wages are not affected by exchange rate regimes. Our numerical experiments suggest that a reduction in trade costs increases both nominal and real wage comovements, regardless of regimes. After downward nominal wage rigidity is introduced, the difference in nominal wage comovements under the fixed regime vs. the flexible regime decreases, while that for real wages increases. When we define a fixed exchange rate regime as membership in the European Monetary Union, panel regression results based on data from OECD countries from 1973 to 2012 are broadly consistent with the predictions of the model and numerical experiments.