a b s t r a c tDespite having had the same currency for many years, EMU countries still have quite different inflation dynamics. In this paper we explore one possible reason: country specific labor market institutions, giving rise to different inflation volatilities. When unemployment insurance schemes differ, as they do in EMU, reservation wages react differently in each country to area-wide shocks. This implies that real marginal costs and inflation also react differently. We report evidence for EMU countries supporting the existence of a cross-country link over the cycle between labor market structures on the one side and real wages and inflation on the other. We then build a DSGE model that replicates the data evidence. The inflation volatility differentials produced by asymmetric labor markets generate welfare losses at the currency area level of approximately 0.3% of steady state consumption.

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The endorsement of expansionary fiscal packages has often been based on the idea that large multipliers can counteract rising and persistent unemployment. We explore the effectiveness of fiscal stimuli in a model with matching frictions and endogenous participation. Results show that hiring subsidies, contrary to increase in government spending, deliver large multipliers, even with distortionary taxation. Those policies increase the incentives to post vacancies, hence employment. Furthermore, by reducing marginal costs they also reduce inflation and increase private consumption.

We study trade policy in a two-sector Krugman (1980) trade model, allowing for production, import and export subsidies/taxes. We consider non-cooperative and cooperative trade policy, first for each individual instrument and then for the situation where all instruments can be set simultaneously, and contrast those with the efficient allocation. While previous studies have identified the home market externality, which gives incentives to agglomerate firms in the domestic economy, as the driving force behind non-cooperative trade policy in this model, we show that this, in fact, is not the case. Instead, the incentives for a non-cooperative trade policy arise from the desire to eliminate monopolistic distortions and to improve domestic terms of trade. As a consequence, terms-of-trade externalities remain the only motive for international trade agreements in the Krugman (1980) model once a complete set of instruments is available.

We study trade policy in a two-sector Krugman (1980) trade model, allowing for wage, import and export subsidies/taxes. We study non-cooperative trade policies, first for each individual instrument and then for the situation where all instruments can be set simultaneously, and contrast those with the efficient allocation. We show that in this general context there are four motives for non-cooperative trade policies: the correction of monopolistic distortions; the terms-of-trade manipulation; the delocation motive for protection (home market effect); the fiscal-burden-shifting motive. The Nash equilibrium when all instruments are available is characterized by first-best-level wage subsidies, and inefficient import subsidies and export taxes, which aim at relocating firms to the other economy and improving terms of trade. Thus, the dominating incentives for non-cooperative trade policies are the fiscal-burden-shifting motive and terms-of-trade effects.