Labor market flexibility and exchange rate regimes

Based on the optimum currency area (OCA) theory, labor market flexibility can be viewed as a key condition determining whether a geographical entity is a good candidate to become part of a currency union — or adopt any type of a fixed exchange rate regime, for that matter. It is therefore surprising that there have been no attempts so far in the literature to quantitatively investigate the relationship between labor market flexibility and currency regime choices in an in-depth manner. In this context, we investigate whether economies with more flexible labor markets are more likely to have a higher degree of exchange rate fixity. We find empirical support for our hypothesis with a global time-series cross-sectional sample. The findings are robust to different classifications of the dependent variable and instrumental variable estimation.