2 Ian Babetskii
Nontechnical Summary
A fixed exchange rate regime eliminates one degree of freedom in absorbing macroeconomic
shocks. Therefore, there is a call for higher labor market flexibility in countries which are
members of the monetary union or those which intend to join the monetary union. Focusing on the
cross-country analysis of labor markets in the enlarged European Union, this paper aims to assess
empirically whether steps towards the European Monetary Union (EMU) indeed go hand in hand
with higher wage flexibility in reality.
Due to limited and even declining mobility of workers within the new member states, and given
the formal restrictions on the free movement of labor for new EU members, it is unlikely that
migration can be considered an efficient tool for coping with adverse shocks. This paper,
therefore, focuses on aggregate wage adjustment. A comparable quarterly data-set is constructed
covering 1995-2004 for four central European states (CE-4), four new EU members already
participating in the Exchange Rate Mechanism-II (ERM-II participants), and three peripheral
members of the euro area (EMU-3).
We apply alternative econometric techniques to determine the extent to which aggregate wages
can accommodate shocks in the economy. The macroeconomic data does not seem to support the
argument that the degree of wage adjustment is significantly higher for countries which already
participate in the ERM-II. Nor is wage flexibility higher in the three EMU members selected. In
addition, a complementary comparison of wage flexibility across countries is done based on
institutional characteristics of labor markets. The pattern of rigidities at the micro level does not
differ much from the estimated macroeconomic indicators of wage flexibility.
Several policy implications follow from the analysis. First, a lack of wage flexibility is considered
to be one of the costs of euro adoption. However, the costs should be assessed against the
potential benefits of joining the euro area. Second, joining the euro area is not likely to lead
automatically to higher wage flexibility. Therefore, there is a call for adopting more flexible labor
market policies in the monetary union in order to be better able to address asymmetric shocks.
Third, the observed decrease in real wage flexibility in several countries, or the absence of such,
could be at least partially linked to a decline in inflation in the new member states over the past
decade. Last but not least, if the central bank sets its inflation target at too low a level, there might
not be enough room for real wage adjustments.