Nominal Wage Flexibility, Wage Indexation and Monetary Union

Membership in a monetary union implies stronger incentives for nominal wage flexibility in the form of wage indexation and shorter contract length than non-membership. This counteracts the stabilisation policy cost of giving up monetary independence. But more wage flexibility is only an imperfect substitute for an individual monetary policy. It is possible that an increase in wage flexibility is welfare-decreasing because of the accompanying rise in price variability. The interaction between wage setting and central bank behaviour may result in either multiple equilibria or a unique full-indexation equilibrium. Copyright 2006 Royal Economic Society.