Macro Welfare Effects of Flexible Labor Contracts ∗

We develop a Dynamic-Stochastic-General-Equilibrium model to study the macro welfare effects of flexible labor contracts. Capturing the empirical properties observed in the data, we incorporate two labor sectors in our DSGE framework: a fixed sector and a flexible sector. The fixed sector offers contracts that exhibit rigidities in working-hours and wages while the flexible sector offers flexible contracts in both dimensions. We calibrate the model utilizing Eurozone data and show that in the benchmark currency union economy, welfare would monotonically increase if fixed sector’s wage rigidity goes up, while welfare would monotonically decline in wage rigidity if the benchmark economy were to switch to inflation targeting. We also show that it is the working-hour flexibility of flexible labor contracts that reinforces the desirability of wage stickiness in the fixed sector. Finally, we obtain strikingly different optimal flexible sector sizes for economies in currency union and inflation targeting monetary policy regimes: while the optimal flexible sector size for a currency union economy turns out to be 0%, the optimal flexible sector size for an economy with inflation targeting is 100%. These important results prevail because large fluctuations in consumption associated with flexible labor arrangements are too costly for households in a currency union with limited monetary policy flexibility - outweighing the production flexibility gains from flexible labor contracts. In this respect, our paper formalizes the welfare concerns related to the growing flexible labor sector sizes in Eurozone and urge policy makers to pay special attention to regulations that induce more flexible labor arrangements in this region