Labour Market Reform and the Effectiveness of Monetary Policy in EMU

This paper analyses the interaction between a common monetary policy and differentiated labour market institutions. We develop a model of a two country monetary union. In each country, labour markets are distinguished by the degree of centralisation in wage bargaining. In each country the government can also use an instrument (general taxation or payroll taxes) to influence their overall labour costs. Finally a common monetary policy is followed in a "conservative" manner, as defined by Rogoff (1985). The results show structural and preference asymmetries matter, both in the determination of economic policy and in performance. In particular, centralised labour market institutions confer a certain comparative advantage in policy making which provides a natural incentive for the less flexible (or less reformed) to want to join a currency union; and also for the more flexible to stay outside. This lowers the incentives for reform inside the union, as Calmfors and others have conjectured.