Wage Rigidity and Monetary Union

We compare monetary union to flexible exchange rates in an asymmetric, three-country model with active monetary policy. Unlike Friedman's (1953) case for flexible rates, we find that countries with high degree of nominal wage rigidity are better off in a monetary union. Their benefits increase with the size of the union and the degree of wage rigidity of its members. Those with relatively more flexible wages fare better under a flexible rate regime. Their cost of participation in a monetary union increases with the union's level of wage rigidity as well as its tolerance of inflation variability. Taking into account actual asymmetries in the EU we find that the status quo (France and Germany in EMU, the UK pursuing a flexible rate) represents the best monetary arrangement for each of these countries. All three would likely be worse off if the UK joined EMU.