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Equilibrium Unemployment, Job Flows and Inflation Dynamics

A classic challenge that macroeconomists face is to explain the cyclical fluctuations of output, unemployment and inflation. Recently, New Keynesian (NK) business cycle models have made important advances in explaining the links between money and the joint dynamics of output and inflation.

However, the standard NK model abstracts from unemployment as it assumes a neoclassical labor market in which individuals vary the hours that they work, but the number of people working never changes. This of course implies that the model cannot account for evidence regarding the effects of aggregate shocks, in particular monetary shocks, on unemployment dynamics.

Moreover, when accounting for the joint response of output and inflation to monetary shocks, the standard NK modelhasagreat difficulty in replicating the sluggish response of inflation together with the large and persistent response of output. One key reason for this difficulty is that the model has the labor input adjusting along the intensive margin, which makes real wages very responsive over the cycle unless an implausibly high labor supply elasticity is assumed.

This inturn induces firms setting prices asamarkup over marginal costs to make large price adjustment and causes inflation in the model to fluctuate more than evidence suggests. Based on these and related considerations, several recent papers have argued that labor market frictions are crucial to understanding business cycle fluctuations, as well as the effects of monetary shocks and the design of monetary policies. The search and matching model, along the lines of the work of Mortensen and Pissarides (1994), is a natural way of thinking about these frictions.

Equilibrium Unemployment, Job Flows and Inflation Dynamics