Labor Markets and Monetary Policy: A New Keynesian Model with Unemployment

Authors: Olivier Blanchard and Jordi Galí

American Economic Journal: Macroeconomics, Vol. 2, No 2, 1-30, April, 2010

We construct a utility-based model of fluctuations with nominal rigidities and unemployment. We first show that under a standard utility specification, productivity shocks have no effect on unemployment in the constrained efficient allocation. That property is also shown to hold, despite labor market frictions, in the decentralized equilibrium under flexible prices and wages. Inefficient unemployment fluctuations arise when we introduce real-wage rigidities. As a result, in the presence of staggered price setting by firms, the central bank faces a trade-off between inflation and unemployment stabilization, which depends on labor market characteristics. We draw the implications for optimal monetary policy.