In ation dynamics with labour market matching : assessing alternative speci cations

This paper reviews recent approaches to modeling the labour market, and assesses their implications for ination dynamics through both their e¤ect on marginal cost and on price-setting behavior. In a search and matching environment, we consider the following modeling setups: right-to-manage bargaining vs. e¢ cient bargaining, wage stickiness in new and existing matches, interactions at the rm level between price and wage-setting, alternative forms of hiring frictions, search on-the-job and endogenous job separation. We nd that most speci cations imply too little real rigidity and, so, too volatile ination. Models with wage stickiness and right-to-manage bargaining, with rm-speci c labour and/or endogenous separation emerge as the most promising candidates. JEL Classi cation System: E31,E32,E24,J64 Keywords: Ination Dynamics, Labour Market, Business Cycle, Real Rigidities. *Correspondence and a¢ liations: Christo¤el, Linzert: European Central Bank, Kaiserstraße 29, D60311 Frankfurt; kai.christo¤el@ecb.int, tobias.linzert@ecb.int. Costain: División de Investigación, Servicio de Estudios, Banco de España, Calle Alcalá 50, E-28014 Madrid; james.costain@bde.es. de Walque: National Bank of Belgium Research Department, Boulevard de Berlaymont 14, B-1000 Brussels; gregory.dewalque@nbb.be. Kuester: Research Department, Federal Reserve Bank of Philadelphia, Ten Independence Mall, Philadelphia, PA 19106, USA; keith.kuester@phil.frb. org. Millard: Bank of England, Threadneedle Street, London EC2R 8AH, UK; stephen.millard@bankofengland.co.uk. Pierrard: Olivier.Pierrard@bcl.lu; Banque Centrale du Luxembourg, 2, boulevard Royal, L-2983 Luxembourg. Without implication, we would like to thank Raf Wouters for taking the initiative in suggesting this project and participants in the Eurosystem Wage Dynamics Network for helpful comments. The views expressed in this paper are those of the authors and do not necessarily reect the views held by the European Central Bank, any other central bank in the Eurosystem, the Bank of England, the Federal Reserve Bank of Philadelphia or the Federal Reserve System. 1 Introduction and motivation The key task of central banks is to maintain price stability by controlling ination and, for this reason, it is important to understand what drives the dynamics of ination. A crucial element of this is the underlying nature of nominal and real frictions associated with the adjustments of prices in the economy. A long tradition in monetary economics, starting with Phillips (1958), has assigned labour market frictions and, in particular wage-setting frictions, a central role in ination dynamics. This paper analyses and compares existing labour market modeling approaches within the New Keynesian business cycle model setup. In particular, it explains their implications for the behaviour of marginal cost and ination in theory and quantitatively using a common calibration based on euro-area data. The paper highlights which of the particular features of each modeling approach are key for driving ination dynamics and provides a structure to the rich variety of modeling approaches in the existing literature.1 We follow an active strand of research that has set out to model the labour market more explicitly within the New Keynesian business cycle model, most often opting for including variants of the Mortensen and Pissarides (1994) model of search and matching frictions. The rationale for so doing comes from the belief that sluggish responses in labour market variables to shocks are a natural place to look for the origins of the sluggish response of ination to shocks. In terms of the New Keynesian framework, labour market frictions will alter either aggregate marginal cost or the rmsprice-setting behaviour for given marginal cost.2 However, so far, the implications for ination dynamics seem to be mixed. Some have, for example, argued that accounting for equilibrium unemployment increases the resilience of marginal cost, and hence ination, to shocks by adding a pool of slack resources; see, e.g., Trigari (2005) and Walsh (2005). Others, e.g., Krause and Lubik (2007), conclude that contrary to received wisdom wage rigidity does not impact on ination inertia.3 As a starting point, we choose the e¢ cient bargaining version of Trigari (2006): that is, a plain New Keynesian model with search and matching frictions and a distinction between heads and hours. Building on this, we replace certain assumptions on the labour market structure by others, one at a time. We consider the following vari1Other papers, largely sparked by Shimers (2005) critique, seek to improve the modelling of calibration of the labour market per se, and are not necessarily concerned with nominal frictions, e.g., Gertler and Trigari (2006), Fujita and Ramey (2005) and Yashiv (2006). In this paper, we take up some of the suggestions made in these papers, as  through their implications for the behaviour of wages and unemployment they also imply changes in the behaviour of real marginal cost. 2Thus, the labour market was seen as a source of real rigidities. For an overview of the extensive literature on real rigidities more generally, see Woodford (2003). 3Another strand of iterature has been concerned with normative implications, such as the design of optimal monetary policy; see, e.g., Blanchard and Gali (2006), Faia (2008), Tang (2006).