Monetary Union: Why Small Countries Have more Flexible Labor Markets*

This paper explores the impact of country size on labor market flexibility in a monetary union with a common monetary policy as conducted in EMU. I apply a Barro-Gordon framework and test its result empirically for EMU. Results confirm that small countries demand higher labor market flexibility than large countries. Small countries use labor market flexibility to be protected against monetary policy in favor of large countries and use flexibility as a substitute for monetary policy. Thereby, national inflation volatilities and unemployment volatility are important determinants. Business cycle synchronization reduces the need of small countries for additional labor market flexibility