Why should Southern economies stay in the Euro Zone? The role of labor markets

We assume a world of two countries in a fixed exchange rate system. These countries differ in the features of their labor markets. The home country is characterized by a dual labor market, with formal and informal sectors. In the foreign country, a nominal wage rigidity exists. In this context, the situation of the labor markets in each country is not optimal owing to a misallocation of workers between sectors in the domestic economy and unemployment in the foreign economy. We show that a devaluation of domestic currency implies a fall in production in each country and deterioration of labor markets in both countries.