Macro Welfare Effects of Flexible Labor Contracts

We develop a small open economy DSGE model to study the macro welfare effects of flexible labor contracts for an economy in a currency union. The framework exhibits two sectors: a fixed sector and a flex sector. The fixed sector offers contracts that exhibit rigidities in working-hours and wages while the flex sector offers flex contracts in both dimensions. We find that the flex sector has a welfare-enhancing role in accommodating shocks, if the fixed sector’s hour adjustment exhibits a high degree of rigidity; and moreover, the presence of the flex sector reduces the desirability of rigid wages in the fixed sector. The welfare analysis also reveals an optimal flex sector size. With the baseline parameterization, a flex sector of 20% of the overall employment maximizes the macro welfare. Our results have important policy implications for a wide range of countries in European-Monetary-Union -characterized by growing and large flex sectors.