Employment and unemployment áuctuate a great deal over the business cycle. Macroeco-nomic models have di¢culty accounting for this fact. See for example the classic real busi-ness cycle models of Kydland and Prescott (1982) and Hansen (1985). Models that buildon the search-theoretic framework of Diamond (1982), Mortensen (1985) and Pissarides(1985) (DMP) also have di¢culty accounting for the volatility of labor markets, see Shimer(2005a). In both classes of models, the problem is that real wages rise sharply in businesscycle expansions, thereby limiting Örmsí incentives to expand employment. The proposedsolutions depend on controversial assumptions, such as high labor supply elasticities or highreplacement ratios.
Empirical New Keynesian models have been relatively successful in accounting for thecyclical properties of employment. However, they do so by assuming that wage-setting is sub- ject to nominal rigidities and that employment is demand-determined.
These assumptionsprevent the sharp rise in wages that limits the employment responses in standard models.Empirical New Keynesian models have been criticized on at least four grounds. First, thesemodels do not explain wage inertia, they just assume it. Second, agents in the model wouldnot choose the wage arrangements that are imposed upon them by the modeler.
Third,empirical New Keynesian models are inconsistent with the fact that many wages are con-stant for extended periods of time. In practice, these models assume that agents who do notreoptimize their wage simply index it to technology growth and ináation.
So, these modelspredict that all wages are always changing. Fourth, these models cannot be used to examinesome key policy issues such as the e§ects of an extension of unemployment beneÖts.In this paper we develop and estimate a model that accounts for the response of keymacro aggregates, including labor market variables like wages, employment, job vacanciesand unemployment to identiÖed monetary policy shocks, neutral technology shocks andinvestment-speciÖc technology shocks. In contrast to leading empirical New Keynesian mod-els, we do not assume that wages are subject to exogenous nominal rigidities. Instead, wederive wage inertia as an equilibrium outcome. Like empirical New Keynesian models, we
For discussions of high labor supply elasticities in real business cycle models, see for example, Rogersonand Wallenius (2009) and Chetty, Guren, Manoli and Weber (2012). For discussions of the role of highreplacement ratios in DMP models see for example, Hagedorn and Manovskii (2008) and Hornstein, Kruselland Violante (2010).
For example, Christiano, Eichenbaum and Evans (2005), Smets and Wouters (2003, 2007) and Gali,Smets and Wouters (2012) assume that nominal wages are subject to Calvo-style rigidities.
This criticsm does not necessarily apply to a class of models initially developed by Hall (2005). Wediscuss these models in the conclusion.
See, for example, Christiano, Eichenbaum and Evans (2005), Smets and Wouters (2007), Justiniano,Primiceri and Tambalotti (2010), Christiano, Trabandt and Walentin (2011), and Gali, Smets and Wouters(2012).