The Shocks Matter: Labor Mobility and the Welfare Cost of a Currency Union

In this paper, we study the impact of labor mobility on the welfare cost of a currency union in an open economy New Keynesian model. We find that the relationship between labor mobility and exchange rate flexibility depends on the source of asymmetric regional shocks. With demand shocks, labor mobility reduces the welfare cost of a union by reducing the cost of shifting labor to concentrated areas of high demand. With supply shocks, flexible exchange rates can work in conjunction with higher labor mobility to reallocate the factors of production to higher productivity regions of potential currency areas. Therefore, higher labor mobility can widen the welfare gap between fixed and flexible exchange rate regimes, implying areas with high inter-regional labor mobility may benefit more from exchange rate flexibility.