Should central banks really be flexible?

Abstract:

In this paper the author shows 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 stabilises economic shocks and reduces output volatility. This enables trade unions to realise 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 effect 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.

The author is Hans Peter Grüner.