Wage Flexibility and Openness

This paper analyzes the degree of short-run, real wage flexibility in a two-sector economy under floating rates.This is done by deriving optimal wage indexation in a contracting framework.We find that the more closed the economy, the lower the degree of wage indexation.As a result, output will fluctuate less around its desired level in a more closed economy.These findings further imply that a given unexpected monetary shock will cause a smaller output shock in a more open economy, whereas a given real shock will induce a smaller output shock in a more closed economy.