Dynamic, stochastic, general equilibrium models based on the New Keynesian paradigm have become a powerful tool to investigate the propagation of shocks and inflation dynamics. In this framework price rigidities establish a link between nominal and real activity: if nominal prices are staggered, fluctuations of nominal aggregates trigger fluctuations of real aggregates. Using this framework, seminal work by Gali and Gertler (1999) has documented that the dynamic behaviour of inflation is tightly linked with firms marginal cost (represented by unit labour cost), whose dynamics crucially depend on the functioning of the labour market.
Gali and Gertler (1999) assume frictionless labour markets. However, empirical evidence from virtually all the major industrialised countries, as surveyed by Bean (1994) and Nickell (1997), shows that labour markets are characterised by frictions that prevent the competitive allocation of resources. As shown in Krause and Lubik (2007), these frictions, once incorporated in a New Keynesian model, enrich the notion of marginal cost, by incorporating the costs of establishing a work relationship over and above the unit labour cost, thereby, in principle, altering the dynamics of inflation. A growing number of empirical studies document that embedding labour market frictions into a standard New Keynesian model increases the modelns empirical performance and enables a more accurate description of inflation dynamics.
The contribution of our paper is two&fold. First, we build on these previous studies to estimate a New Keynesian model characterised by labour market frictions on UK data. This estimation allows us to recover the structural parameters of the UK economy, the unobservable shocks and study their transmission mechanism. Second, we investigate how staggered wage negotiations affect the propagation of shocks and the ability of the model to fit the data. To this end, the theoretical framework allows, but does not require, nominal wage rigidities to affect the modelns dynamics, therefore leaving the data to establish the importance of wage rigidities. In particular, this estimation strategy allows us to investigate the effect of nominal wage rigidities on inflation.
Our findings are the following. First, we estimate important structural parameters of the labour market that characterise the British economy. In particular, we identify a relatively low Frish elasticity of labour supply, reflecting the fact that employment is more volatile along the extensive margin than the intensive margin. The estimate of the ratio of the income value of non working activity over wages is about 77%. As pointed out by Costain and Reiter (2008), this estimate is consistent with a semielasticity of unemployment to unemployment insurance equal to 2, which is in line with empirical evidence. This finding casts doubt on the argument by Hagedorn and Manovskii (2008) that a high opportunity cost of working be a plausible solution of the unemployment volatility puzzle in the UK. Similar results have been obtained by Gertler et al. (2008) using US data.
The elasticity of the matching function with respect to unemployment is equal to 0.55, lower than the estimates of 0.7 in Petrongolo and Pissarides (2001), suggesting that the number of new hires equally depends on the number of unemployed workers as well the number of vacancies posted. The estimate of the job destruction rate is approximately equal to 7%, higher than the estimates from microdata which range from 3%, as estimated by Bell and Smith (2002), to 4.5%, as given by Hobijn and Sahin (2007). We also provide estimates for the monetary authority reaction function. We find that the monetary authorityns response to inflation is particularly strong and there is a mild degree of interest rate inertia, while the response to output fluctuations is robust.
The estimated model allows us to characterise the transmission of shocks. We investigate how the model variables react to supply and demand shocks, and we find that shocks to preferences and the labour supply are more important than technology and monetary policy shocks in explaining the data.
Finally, using a Kalman filter on the modelns reduced form we provide estimates for the unobservable shocks that characterised the post 1970s British economy. In general, we find that the magnitude of shocks has somewhat decreased since the mid&1990s, with the exception of preferences shocks, whose size has remained broadly unchanged. Furthermore, similarly to studies for other countries, we find that the volatility of monetary policy shocks declined after the mid&1990s. These findings corroborate the results of empirical studies, such as Benati (2007) and Bianchi et al. (2009), which detected a period of macroeconomic stability triggered by a lower volatility of shocks in the UK during the past decade.
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