Labor Market Heterogeneity and Optimal Exchange Rate Regime in Resource-Rich MENA Countries

Although countries of the MENA region are commonly considered as primary-commodity economies, they show sharp dissimilarities in a number of dimensions. Two important dimensions are the size of resource endowments and the degree of labor market flexibility. Countries such as members of the Gulf Cooperation Council (GCC) and Libya are highly oilendowed economies with largely flexible labor markets and substantial remittances outflows. While the rest of the MENA countries, such as Egypt, Sudan, Yemen, Algeria, Iran and Iraq, show commonalities in terms of their relatively smaller oil-endowments and the lack of labor market flexibility. This paper attempts to incorporate the role of labor market flexibility in a unified theoretical framework of optimal exchange rate policies. For that purpose, the paper extends the standard rules-vs.-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), 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. On the other hand, the fixity of exchange rates combined with rigid goods and labor markets can add to real appreciations.