Labor market heterogeneity and optimal exchange rate regimes in resource-rich Arab countries

This chapter attempts to incorporate the role of labor market flexibility in a unified theoretical framework of optimal exchange rate policies for resource-rich economies. For that purpose, the chapter extends the standard rules-versus-discretion model of monetary policy to allow for different assumptions about wage rigidities. The analysis suggests that when all prices are exogenous and wages are all optimally indexed to inflation (i.e., labor market flexibility case), fixed exchange rate regimes deliver more desirable outcomes in terms of real output, inflation and insulation against external shocks compared to flexible exchange rate regimes. Meanwhile, the fixity of exchange rates combined with rigid goods and labor markets can add to real appreciations.