DP6765 Labour Markets and Monetary Policy: A New Keynesian Model with Unemployment

Author(s): Olivier J Blanchard, Jordi Galí
Publication Date: March 2008
Keyword(s): Labour market frictions, New Keynesian Model, real wage rigidities, search model, sticky prices, unemployment
JEL(s): E32, E50
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=6765

We construct a utility-based model of fluctuations, with nominal rigidities and unemployment, and draw its implications for the unemployment-inflation trade-off and for the conduct of monetary policy. We proceed in two steps. We first leave nominal rigidities aside. We show that, under a standard utility specification, productivity shocks have no effect on unemployment in the constrained efficient allocation. We then focus on the implications of alternative real wage setting mechanisms for fluctuations in unemployment. We show the role of labour market frictions and real wage rigidities in determining the effects of productivity shocks on unemployment. We then introduce nominal rigidities in the form of staggered price setting by firms. We derive the relation between inflation and unemployment and discuss how it is influenced by the presence of labour market frictions and real wage rigidities. We show the nature of the trade-off between inflation and unemployment stabilization, and its dependence on labour market characteristics. We draw the implications for optimal monetary policy.