Optimal exchange rate flexibility with large labor unions

• We model large labor unions in a standard New Open Economy Macroeconomics framework.
• Labor market structure affects optimality of exchange rate volatility under Local currency pricing (LCP).
• Curbing exchange rate fluctuations reduces inflationary wage pressure under LCP.

We study the optimal volatility of the exchange rate in a two-country model with sectoral non-atomistic wage setters, non-traded goods, nominal rigidities and alternative pricing assumptions – producer or local currency pricing. Labor unions internalize the sectoral impact of their wage settlements through firms' labor demand. With local currency pricing, exchange rate depreciation raises sales revenue, which in turn boosts domestic consumption and labor demand. Unions anticipate this effect and set higher wages accordingly. With small unions and low wage markup, optimal monetary policy enhances exchange rate movements to improve its terms of trade. With large unions and high wage markup, optimal monetary policy curbs exchange rate movements to restrain inflationary wage demands and to stabilize employment.