Abstract

<em>Revised May 2011</em><br>We develop a reformulated version of the Smets-Wouters (2007) framework that embeds the theory of unemployment proposed in Galí (2011a,b). We estimate the resulting model using postwar U.S. data, while treating the unemployment rate as an additional observable variable. Our approach overcomes the lack of identifification of wage markup and labor supply shocks highlighted by Chari, Kehoe and McGrattan (2008) in their criticism of New Keynesian models, and allows us to estimate a "correct" measure of the output gap. In addition, the estimated model can be used to analyze the sources of unemployment fluctuations.