Gradual wage-price adjustments, labor market frictions and monetary policy rules

In this paper the role of different types of labor market frictions in the dynamics of output and inflation is investigated. For this purpose, the Keynes–Goodwin model discussed in Chen et al. (2006) and Franke et al. (2006) is extended by a labor search and matching module along the lines of Mortensen et al. (1994). After estimating the resulting model with U.S. aggregate time series and comparing its dynamics with those of a VAR model, the performance of different types of monetary policy rules for inflation, and more generally, for macroeconomic stability is analyzed.

► The role of different types of labor market frictions in the dynamics of output, employment and functional income distribution is investigated in a semi-structural macroeconomic model based on gradual wage-price adjustments to disequilibria in the goods- and the labor markets.
► The paper delivers a theoretical framework for the analysis of the distinction between external and internal labor market flexibility.
► The theoretical model predicts dynamic adjustments to unexpected monetary policy shocks are similar to the impulse–response functions of an unrestricted VAR model of the U.S. economy.
► By means of numerical simulations, different types of monetary policy rules are evaluated.