Monetary Policy, Trend Inflation and Unemployment Volatility

BY Sergio Lago Alves

http://d.repec.org/n?u=RePEc:bcb:wpaper:450&r=dge

The literature has long agreed that the canonical DMP model with search and matching frictions in the labor market can deliver large volatilities in labor market quantities, consistent with US data during the Great Moderation period (1985-2005), only if there is at least some wage stickiness. I show that the canonical model can deliver nontrivial volatility in unemployment without wage stickiness. By keeping average US inflation at a small but positive rate, monetary policy may be accountable for the standard deviations of labor market variables to have achieved those large empirical levels. Solving the Shimer (2005) puzzle, the role of long-run inflation holds even for an economy with flexible wages, as long as it has staggered price setting and search and matching frictions in the labor market.

Another nail in the coffin of the Shimer puzzle, this time with a straightforward model and without stretching the calibration too much.

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