Incorporating labour market frictions into an optimising-based monetary policy model

This paper examines the effects of introducing a non-Walrasian labour market into the “New Neoclassical Synthesis” framework. A dynamic stochastic general equilibrium model is formulated, solved and calibrated in order to evaluate its ability to replicate the main features of the Euro area economy. This framework allows us to study the effects of labour market rigidities, nominal rigidities and other frictions to give account of the impact of monetary policy, technology and public spending shocks. Our simulations show that: (i) real rigidities do not act as a substitute for nominal rigidities but as a necessary complement; (ii) the Beveridge and Phillips relations are reproduced; (iii) hours worked are too sensitive an adjustment variable; and (iv) the real wage dynamics is still procyclical.