International Spill-over Effects of Labour Market Rigidities∗ Preliminary version- comments welcome

We analyse the effects of real wage rigidities in a stochastic two-country general equilibrium model. It is shown that real wage rigidities in one country make consumption more volatile in both countries. Moreover, we find that expected consumption is affected by rigidities. Both the ex-pected value and the variance of consumption are important for welfare. Assuming that the choice of whether or not to adopt flexible wages is in the hands of labour unions within each country, this leads us to derive po-tential Nash equilibria in wage setting structures. We find that depending on the parameter values of the model either no, one or both countries will choose flexible wages. Hence, even in this symmetric model we may end up an an equilibrium where wages are flexible in one country and rigid in the other. Since there are international spillover effects of the choice of wage setting regime the outcome of a coordinated labour market pol-icy is also considered, and it is shown that an internationally coordinated labour market policy may be welfare improvin