Persistent Monetary Policy in a Model with Labor Market Frictions

Abstract

In a basic New Keynesian DSGE model with involuntary unemployment and inflation target shocks, we study the role of labor markets in the transmission of persistent monetary policy shocks that increase households' inflation expectations. The model predicts that labor market conditions can play important role in the transmission channel of the persistent inflation target shock: quantitatively realistic labor market frictions increase the expansionary effect of inflation target shock on output by around a half compared to that under the model without labor market frictions. Using a VAR analysis, we further provide empirical evidence consistent with the predictions of our theoretical model.