Presenter: Vytautas Kuokštis (Vilnius University, Institute of International Relations and Political Science).
What is the effect of labor market flexibility on the choice of an exchange rate regime? According to the optimum currency area (OCA) theory, labor market flexibility is one of the key criteria that determine whether a geographical entity is a good candidate to become part of a currency union — or adopt any type of fixed exchange rate regime, for that matter. Fixing the exchange rate entails the loss of monetary independence as a tool to counter competitiveness problems and unemployment. Labor market flexibility that reduces downward wage rigidity and facilitates labor reallocation is considered to be a crucial alternative adjustment mechanism – whether in a currency union or under any type of currency peg. This theoretical conclusion is well-established and has become part of conventional wisdom in academic and policy circles, underpinning a number of adjustment programmes in the euro area during its sovereign debt crisis. It is therefore surprising that there have been no attempts so far in the literature to quantitatively investigate the relationship between labor market flexibility and currency regime choices in an in-depth manner. In this context, we investigate whether economies with more flexible labor markets would be more likely to enter into a fixed exchange rate system. We use the de facto exchange rate regime as our dependent variable, and the composite labor market regulation indicator from the Fraser Institute’s Economic Freedom of the World database as the main explanatory variable, while controlling for a host of standard economic and political variables. The data covers 123 countries (both developed and developing) and spans the years 1970-2016. We find empirical support for our hypothesis — an increase in the labor market flexibility is associated with a decrease of the flexibility of the exchange rate regime. However, this result only holds for the developing countries. The findings are robust to different classifications of the dependent variable, the use of time and country fixed effects, as well as an instrumental variable estimation.