The introduction of nominal rigidities in microfounded models (so called New Keynesian models) brought enormous consequences for Macroeconomics, in general, and Monetary Economics, in particular. At first, nominal frictions lead to short run real effects from demand side shocks breaking down the classical dichotomy between nominal and real variables that was present in Neoclassical models (Fischer, 1977; Taylor, 1979; and Blanchard and Fischer, 1989, chapter 8).
A second wave of papers (Hairault and Portier, 1993; Yun, 1996) showed how incorporating price stickiness is key to replicate, in a realistic fashion, the business cycle responses of inflation and output to technology and monetary shocks. Moreover, New Keynesian models predict that the level of employment (total hours) falls after an expansionary technology shock as empirically supported by Galí (1999) and Francis and Ramey (2005). Last but not least, New Keynesian models have become the working instrument for much of the latest monetary policy analysis due to both its theoretical appeal, as they overcome the Lucas (1976) critique, and its empirical plausibility. Two widely used books on Monetary Economics, recently published, that rely the analysis upon the New Keynesian framework are Walsh (2003), and Woodford (2003).
However, todayjs New Keynesian framework is little Keynesian in one particular sense. It is commonly presented as a General Equilibrium model that ignores the presence of unemployment in the labor market. This fails to comply with both the original Keynesian analysis of the labor market (Keynes, 1936, chapters 18%20), and also deviates from the actual functioning of labor market in developed economies where we observe unemployment fluctuations.
The influential paper by Erceg, Henderson and Levin (2000), henceforth EHL, brought a follow up of New Keynesian papers with sticky wages in addition to sticky prices. Representative examples among these papers are Amato and Laubach (2003), Smets and Wouters (2003, 2007), and Christiano et al. (2005). With a somehow different labor market structure, this paper describes a New Keynesian model with sticky prices, sticky wages, and also unemployment. I voluntarily stress the word also because the New Keynesian literature that I just cited incorporate wage setting rigidities that, somehow surprisingly, do not deliver unemployment situations. By contrast, this paper shows how sticky wages can explain unemployment fluctuations.
Following Casares (2007b), labor contracts are set at a nominal wage that matches the amounts of heterogeneous ex ante labor supply and labor demand, expected throughout the length of the contract. Then, unemployment arrives when there are a fraction of wage contracts that cannot be renegotiated every period, allowing possible mismatches between labor supply and labor demand. Such an interpretation of unemployment is inspired in Milton Friedmanjs view of short run unemployment variations, which hinges on the Wicksellian tradition. As described in Friedman (1968, pages 7%11), there can be a discrepancy between the observed unemployment rate and the so called natural rate of unemployment that would be reached in a Walrasian competitive labor market. This flexible wage natural rate of unemployment can be set as a reference value in the labor market; an actual rate of unemployment above the natural rate indicates that there is an excess supply of labor whereas a lower rate of unemployment corresponds to an excess demand for labor. Abstracting from variations in the natural rate of unemployment (normalizing it at zero), the model of this paper explains short run fluctuations of unemployment by the gaps between labor supply and labor demand.
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