Should central banks really be flexible?

Hans Peter Grüner

No 188, Working Paper Series from European Central Bank

Abstract: In this paper I show that central bank flexibility may not be desirable when it encourages trade unions to behave more aggressively. The argument is based on a model where risk averse trade unions interact with a central bank. A flexible central bank stabilizes economic shocks and reduces output volatility. This enables trade unions to realize higher real wages without risking the unemployment of some insider workers. Risk averse insiders demand higher real wages, generate more inflation and more unemployment. The overall e ect on welfare may be negative. A conservative central bank instead increases output and employment on average but raises output volatility. The argument also sheds new light on the issue of optimum currency areas. Wage claims are lower and employment is higher in a currency union if national trade unions expect the central bank to do less to secure employment of insider workers in their country. JEL Classification: E52, E58

Keywords: central bank credibility; central bank flexibility; Optimum Currency Area (search for similar items in EconPapers)
Date: 2002-10
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