The combination of downward nominal wage rigidity and pegged exchange rate creates an externality which leads to excessive wage inflation (Schmitt-Groh_e and Uribe, 2016). This paper re-examines this result assuming that wage setters are forward looking, hence endogenously restrain wage increases facing downward wage rigidity, as in Elsby (2009). In this case, wage inflation is either excessively high or excessively low compared to the social optimum: while wages increase too strongly following demand ...
The combination of downward nominal wage rigidity and pegged exchange rate creates an externality which leads to excessive wage inflation (Schmitt-Groh_e and Uribe, 2016). This paper re-examines this result assuming that wage setters are forward looking, hence endogenously restrain wage increases facing downward wage rigidity, as in Elsby (2009). In this case, wage inflation is either excessively high or excessively low compared to the social optimum: while wages increase too strongly following demand shocks, they rise by too little following Balassa-Samuelson-type technology shocks. Applying the model to euro area countries, I document excessively high wage inflation rates in the euro periphery, but excessively low rates in the euro core, in the pre-crisis period.
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