Influence of institutional factors and wage-setting mechanism in a dual labour market with currency union: Northern Cyprus

Abstract

In this paper, I consider two heterogeneous economies that engage in a currency union. The small economy adopts the currency of the large and is highly dependent on its wealthier partner for trade. The effects of a currency union, deficit financing and institutional restraints on inflation are analyzed in a dual economy with different wage-setting mechanisms. In the model, Northern Cyprus is the small economy and Turkey, being the only country that acknowledges it as an independent state is its larger partner. Features of the labour markets determine the wages. We make a conjecture that wage determination in Northern Cyprus (NC) is conducted with reference to centralized-bargaining and that decentralized bargaining sets the wages in Turkey (TR). Hence, the differences in wage-setting procedures cause a dual labour market. In order to incorporate monetary dependence into the analysis, we let the Turkish central bank to decide on the economic policy measures, in this case the inflation rate and unemployment. The institutional restraints such as economic sanctions increase the inflexibility in the NC and cause shocks to affect the economy more. In order to compensate for the losses that might be endured by the government in NC, TR finances the budget deficit of NC. Therefore, TR government needs to consider the burden of this financing issue