Survey_BG_2006

Abstract

We develop a utility based model of fluctuations, with nominal rigidities, and unemployment. In doing so, we combine two strands of research: the New Keynesian model with its focus on nominal rigidities, and the Diamond-Mortensen-Pissarides model, with its focus on labor market frictions and unemployment. In developing this model, 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 then introduce nominal rigidities in the form of staggered price setting by firms. In our model, frictions in labor markets are introduced by assuming the presence of hiring costs, which increase with the degree of labor market tightness. We sets up a basic model, leaving out nominal rigidities. We capture labor market frictions through external hiring costs. The latter are a function of labor market tightness, defined as the ratio of hires to the unemployment pool. We then characterize the constrained-efficient allocation, and show that productivity shocks have no effect on unemployment. The source of this neutrality is that income effects lead to changes in the wage proportional to changes in productivity–as would be the case in an economy without labor market frictions. Section 3 characterizes the decentralized equilibrium under alternative wagesetting mechanisms. We first assume Nash bargained wages and derive the conditions under which the economy replicates the constrained efficient allocation. We then show that, under Nash bargaining, the neutrality property continues to hold. We then introduce real wage rigidities, and characterize the dynamic effects of productivity shocks on unemployment.Section 4 introduces nominal rigidities, in the form of staggering of price decisions by firms. We show how the model reduces, to a close approximation, to simple relations between inflation, marginal cost, and unemployment. We derive the relation between inflation and unemployment implied by the model, and contrast it to the standard NK formulation. Put crudely, the model implies a significant effect of both the level and the change in unemployment on inflation, given expected inflation.