By Daniela Hauser and Martin Seneca
According to conventional wisdom, a currency area benefits from internal labour mobility. If independent stabilisation policies are unavailable, the argument goes, factor mobility helps regions respond to shocks. Reasonable as it sounds, few attempts have been made to test this intuition in state-of-the-art macroeconomic models. In a recent Staff Working Paper (also available here), we build a DSGE model of a currency area with internal migration to go through the maths. So does the old intuition hold up? The short answer, we think, is yes. Internal labour mobility eases the burden on monetary policy by reducing regional labour markets imbalances. But policymakers can improve welfare by putting greater weight on unemployment. Effectively, interregional migration justifies a somewhat higher ‘lambda’.
Our model is a two-region dynamic stochastic general-equilibrium (DSGE) model with sticky prices and market inefficiencies. It belongs to a new generation of macroeconomic models that takes unemployment and labour market imperfections very seriously, see for example the work by Carlos (2008), Blanchard and Galí (2010) and Ravenna and Walsh (2011). Search and matching frictions mean that workers cannot always find employment and that firms cannot always fill their vacancies. In our model, moreover, unemployed workers make conscious decisions about where to look for work. If wages and job finding prospects are better elsewhere, some workers will choose to migrate and search for a job away from home. Other workers will find the sacrifice too great and stay. In this way, migration flows are determined by relative labour market performance consistent with empirical evidence.
We derive a measure of social welfare from the individual wellbeing of households across our monetary union. Our benchmark is the optimal monetary policy stance defined as the setting of short-term nominal interest rates that delivers the highest social welfare across the union. We can then compare simpler representations of monetary policy against this benchmark.
What is the best policymakers can do?
As in the existing literature, price stability remains the most important concern for monetary policy in our model. In the monetary union, policymakers should focus on a measure of union-wide inflation. Whenever regional developments call for adjustments in relative prices – which cannot simply take place through a move in the exchange rate between independent currencies – the common monetary authority should balance this adjustment against its aims to stabilise inflation in each region. But when labour market frictions are important, simply focusing on inflation is not enough. The policymaker should trade off the speed with which inflation is returned to target with conditions in regional labour markets.
New to our framework is that the common monetary policymaker can improve welfare on the margin by also paying attention to internal migration flows. When individuals decide whether to stay at home or cross the border to look for work, they compare current prospects for wages and job opportunities across regional labour markets. But they do not take account of the effects that their own migration decisions will have on aggregate labour market outcomes. As a result, individuals tend to take too strong a signal from differences in labour market conditions. It is for this reason that monetary policy can improve social welfare by leaning against disparities in regional labour market performance.
The optimal monetary policy strategy is a useful benchmark. It tells us that labour mobility within a currency union provides a further justification for flexibility in inflation targeting. But beyond this general lesson, it sets the bar very high. The optimising policymaker in our model is perfectly informed and manages every trade-off immaculately. In reality, policymakers face numerous unknowns – about the underlying structure of the economy, the effects of monetary policy, and the nature of economic developments.
What if monetary policy really cannot be fine-tuned in practice?
If monetary policy is suboptimal, a mobile labour force can alleviate some of its
short-comings by reducing regional imbalances in labour markets. For example, if monetary policy is a bit too tight, a badly affected region may export some of its unemployment to other regions. The table below illustrates this effect:
|Welfare losses in %
|Optimal policy||Simple flexible rule||Simple rule with
|With labour mobility||0.00||0.45||0.01|
Note: The simple flexible rule is and the simple rule with unemployment is , where is the short-term interest rate at times , is union-wide inflation, is a measure of union-wide output, is union-wide unemployment.
First it shows consequences for welfare relative to optimal monetary policy from following a simple flexible interest-rate rule. It is a rule of the kind often taken to represent actual monetary policy in macroeconomic models. By construction, optimal monetary policy results in zero relative welfare losses. In a version of our model without labour mobility, following the flexible rule would lead to a welfare loss equivalent to about 1% of the level of consumption in normal times. In the model with mobility, the relative welfare loss is cut in half. Migration towards the best performing labour market now helps to compensate for the lack of fine-tuning in monetary policy by reducing costly regional imbalances.
The table also shows welfare losses when policymakers follow a simple rule with weight on inflation and unemployment. This rule is very close to optimal. The case for leaning somewhat against unemployment directly is strong.
Can you give an example?
The figures below show how the monetary union’s economy responds to a sudden temporary increase in productivity in one region, call it the West, but not in the rest of the union, the East.
The black lines show how the economy would respond if households and firms were free from all the frictions they invariably encounter in the market place. In this imaginary economy (real only to the puritans), the economy is only constrained by available resources and the technology that allows firms to transform labour into consumption goods. It represents the best that monetary policymakers can possibly aspire to achieve. Clearly, in this Utopia, workers flow towards the West where they are most productive.
In reality, of course, households and firms do interact in markets and their actions will be shaped by monetary policy through the cost of credit and the return on savings. Figure 1 shows the economy’s responses when policymakers simply lean against inflation instead of optimising. Now the more productive firms in the West can bring more goods to the market. They can only sell them all if prices fall or consumers demand more goods at existing prices. But firms are slow to adjust their prices, and policymakers are slow to stimulate spending. As a result, western firms limit the expansion of production and hire fewer workers. Migrants go east, not west. In this reality more workers are employed where they are least productive. But at least migration helps to avoid a sharp increase in unemployment in the West. In this sense, mobility compensates for policy’s limitations.
Our optimising policymaker can do better as shown in Figure 2. By stimulating spending more aggressively, policymakers allow western firms to sell more goods at current prices. As a result they hire more workers and offer better wages. Migrants now again flow towards the more productive region. In this case, monetary policy and labour mobility pull together to improve welfare across the monetary union.
Our DSGE analysis shows that interregional labour mobility provides a further justification for putting some weight on labour market developments when setting monetary policy for a monetary union. Certainly, labour mobility does not give policymakers licence to simply stabilise inflation at all times and at any cost. The bad news is that labour mobility makes it harder to get monetary policy exactly right. The good news is that labour mobility also reduces the welfare costs of getting policy slightly wrong.
Daniela Hauser works at the Bank of Canada and Martin Seneca works in the Bank’s Monetary Analysis/Monetary Policy Outlook Division.
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