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Double 'Dividend' or Double 'Function' of Labour Market Reforms under Discretionary Monetary Policy? A Note on the Calmfors-Model.

  • Economics
  • Political Science


A high natural rate of unemployment has been identified by the time inconsistency literature as the root cause of an inflation bias. Thus, a reduction of equilibrium unemployment and of the inflation bias requires fundamental reforms of labour market institutions. However, there has been little research on how participation in different monetary regimes affects incentives in favour of them. Here an extended Barro-Gordon model is used where monetary policy and the reforms are determined simultaneously. Impacts of different monetary regimes on labour markets crucially depend on the degree of the inflation bias and on the extent of its internalisation by national governments. However, some opponents to a monetary rule hold the prior that a monetary rule serves a s substitute for labour-market reform. Therefore, it does not lower unemployment significantly and leads to lower welfare than discretionary policy. This view is clearly rejected by our model. It is shown that a monetary rule generally leads to a higher total economy welfare than discretionary policy. Under the latter, an overshooting of reforms can be observed because reforms are needed more pressingly and a monetary rule is a superior (and ideally perfect) instrument to internalise the inflation bias.

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