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  5. Downward Nominal Wage Rigidity and the Case for Temporary Inflation in the Eurozone

Journal of Economic Perspectives

ISSN 0895-3309 (Print) | ISSN 1944-7965 (Online)

Downward Nominal Wage Rigidity and the Case for Temporary Inflation in the Eurozone

  • Stephanie Schmitt-Grohé
  • Martin Uribe
Journal of Economic Perspectives
vol. 27, no. 3, Summer 2013
(pp. 193–212)
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Abstract

Since the onset of the Great Recession in peripheral Europe, nominal hourly wages have not fallen from the high levels they had reached during the boom years -- this in spite of widespread increases in unemployment. This observation evokes a well-known narrative in which nominal downward wage rigidity is at the center of the current unemployment problem. We embed downward nominal wage rigidity into a small open economy with tradable and nontradable goods and a fixed exchange-rate regime. In this model, negative external shocks cause involuntary unemployment. We analyze a number of national and supranational policy options for alleviating the unemployment problem caused by the combination of downward nominal wage rigidity and a fixed exchange-rate regime. We argue that, in spite of the existence of a battery of domestic policies that could be effective in solving the unemployment problem, it is unlikely that a solution will come from within national borders. This leaves supranational monetary stimulus as the most compelling avenue out of the crisis. Our model predicts that full employment in peripheral Europe could be restored by raising the euro area annual rate of inflation to about 4 percent for the next five years.

Citation

Schmitt-Grohé, Stephanie, and Martin Uribe. 2013. "Downward Nominal Wage Rigidity and the Case for Temporary Inflation in the Eurozone." Journal of Economic Perspectives, 27 (3): 193–212. DOI: 10.1257/jep.27.3.193

JEL Classification

  • E24 Employment; Unemployment; Wages; Intergenerational Income Distribution; Aggregate Human Capital
  • E31 Price Level; Inflation; Deflation
  • E32 Business Fluctuations; Cycles
  • E52 Monetary Policy
  • F33 International Monetary Arrangements and Institutions
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