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...6) Similarly, using Eq. (3), Eq. (5) can be expressed as jitAtz R it witðz R itÞ F ð1 l x ÞEtbt;tþ1 w qðytþ1Þ . (7) 2.1.2. Pricing decision Due to imperfect substitutability between individual consumption goods, each firm faces the following demand curve for its product: yit Pit Pt gt yt , (8) where Pit is the firm’s price, Pt is the overall price level, gt41 is the time-varying elasticity of substitution between individual goods in households’ consumption basket and yt is aggregate demand. As is standard in the New Keynesian literature, we assume staggered price adjustment a la Calvo (1983). Let d denote the probability of price adjustment common to all firms. A price-setting firm maximizes Et X1 Tt dTtbt;T Pit PT jiT Pit PT gt yT with respect to Pit . The first-order condition is given by Et X1 Tt dTtbt;T P gT T yT Pit PT mTjiT 0, (9) where Pit is the optimal price decision and mt gt=ðgt 1Þ is a mark-up shock. The latter has law of motion logmt ð1 rmÞ logg=ðg 1Þ þ rm logmt1 þ m t , where g is the steady-state value of gt and m t iidð0;smÞ. 2.2. Households There exists a large, representative household with a measure-one continuum of member...

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...C. Thomas, F. Zanetti / Journal of Monetary Economics 56 (2009) 885–899886unemployment benefits (UB) and firing costs (FC) may influence the volatility of inflation. We focus on UB and FC because they are generally considered to be important contributors to the rigidity of continental European labor markets.2 Therefore, a structural reform aimed at increasing the flexibility of the labor market would certainly involve modifications to these two labor market features. In order to investigate this topic we set up a New Keynesian model with search and matching frictions in the labor market a la Mortensen and Pissarides (1994). In this framework, monopolistically competitive firms set their nominal prices in a staggered fashion. They optimally adjust the size of their workforce both through job creation and job destruction. On the job creation side, firms post vacancies. On the job destruction side, firms destroy those jobs that become unprofitable and pay firing costs for each job destroyed. On the other side of the labor market, unemployed workers search for jobs and receive unemployment benefits in the meantime. Finally, vacancies and unemployed workers meet in the so-called matching function. This framework the...

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...t benefits can have important effects on the volatility of the hiring component of real marginal costs. This, however, has a small effect on inflation volatility, because Euro Area data favor model parameterizations in which hiring costs are small. The analysis of this paper is conducted using a search and matching model of the labor market, which is only one possible way of analyzing the effect of labor market reforms on inflation dynamics. It would be interesting to establish whether the same results carry over to other environments such as the search-island model (Lucas and Prescott, 1974; Ljungqvist and Sargent, 1998, 2006), the insider–outsider model (Blanchard and Summers, 1986; Lindbeck and Snower, 1988), or a model where firms fire workers only in certain states (Bentolila and Bertola, 1990). Within the realm of the search and matching framework, an important extension of the analysis presented here would be to incorporate stickiness in real wages, which is likely to interact with labor market policies in shaping the behavior of inflation. This will prove to be a difficult task, however, because of the theoretical requirement known as the ‘‘Barro critique’’, namely that wage stickiness should not lead...

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... the effect of search frictions in the labor market on inflation dynamics. In particular, Krause et al. (2008) use US data on inflation, unit labor costs and several indicators of labor market activity in order to estimate the New Keynesian Phillips curve that arises in models with search frictions.3 In such models, the cost of hiring workers adds to the usual wage costs as a determinant of marginal costs. Our model features a similar expression for marginal costs, with the addition of a firing cost component. Krause et al. (2008)2 See for instance Bentolila and Bertola (1990), Yashiv (2004), Layard et al. (2005) and Ljungqvist and Sargent (2006). 3 Their empirical implementation is based on theoretical work by Krause and Lubik (2007), Blanchard and Gali (2009) and Rotemberg (2006). See also Ravenna and Walsh (2008). ARTICLE IN PRESS C. Thomas, F. Zanetti / Journal of Monetary Economics 56 (2009) 885–899 887find that hiring costs make a small contribution to real marginal costs and hence to inflation, which points in the same direction as our results for the Euro Area.4 The remainder of this paper is organized as follows. Section 2 lays out the model. Section 3 parameterizes the model to Euro Area dat...

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...is related to previous research that analyzes the effect of search frictions in the labor market on inflation dynamics. In particular, Krause et al. (2008) use US data on inflation, unit labor costs and several indicators of labor market activity in order to estimate the New Keynesian Phillips curve that arises in models with search frictions.3 In such models, the cost of hiring workers adds to the usual wage costs as a determinant of marginal costs. Our model features a similar expression for marginal costs, with the addition of a firing cost component. Krause et al. (2008)2 See for instance Bentolila and Bertola (1990), Yashiv (2004), Layard et al. (2005) and Ljungqvist and Sargent (2006). 3 Their empirical implementation is based on theoretical work by Krause and Lubik (2007), Blanchard and Gali (2009) and Rotemberg (2006). See also Ravenna and Walsh (2008). ARTICLE IN PRESS C. Thomas, F. Zanetti / Journal of Monetary Economics 56 (2009) 885–899 887find that hiring costs make a small contribution to real marginal costs and hence to inflation, which points in the same direction as our results for the Euro Area.4 The remainder of this paper is organized as follows. Section 2 lays out the model. Section 3 par...

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... gt Dt1. (22) Finally, the price level evolves according to Pt dP 1gt t1 þ ð1 dÞðP t Þ 1gt 1=ð1gt Þ. (23)9 For supportive evidence on the plausibility of the Taylor rule as a description of actual ECB monetary policy, see e.g. Christoffel et al. (2008), Rabanal (2009) and Christoffel and Kuester (2009). 10 This does not mean, however, that all firms are symmetric in equilibrium. Given the price dispersion created by staggered price adjustment, firms will also differ in their output levels, yit , the size of their workforce, nit , and their number of vacancies, vit . 11 See e.g. Yun (1996). ARTICLE IN PRESS C. Thomas, F. Zanetti / Journal of Monetary Economics 56 (2009) 885–899 891Equilibrium in this economy is defined as the path fit ; ct ; yt ;nt ;ut ;Dt ; zRt ; yt ;jt ;vt ; Pt ; P t g 1 t0 that satisfies Eq. (9) (without i subscripts), (10), (15)–(23), and the relationship vt ytut , for all t 0, given the evolution of the exogenous shocks, fAt ; g t ; m t ; m t g 1 t0, the laws of motion of fAt ; gt ;mtg and the initial values of the endogenous state variables, fi1;n1;D1; P1g. For future reference, we also define after-hiring unemployment, Ut 1 nt , whi...

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...value of gt and m t iidð0;smÞ. 2.2. Households There exists a large, representative household with a measure-one continuum of members. A fraction nt R 1 0 nit di of its members are employed. The remaining members are engaged in home production, receive unemployment benefits and search for jobs. All members pool their resources so as to ensure equal consumption.6 The household consumes the following basket of differentiated goods, ct Z 1 0 c ðgt1Þ=gt it di !gt=ðgt1Þ . 6 The assumption of perfect insurance of unemployment risk is standard in the search and matching literature. See e.g. Merz (1995) and Andolfatto (1996). ARTICLE IN PRESS C. Thomas, F. Zanetti / Journal of Monetary Economics 56 (2009) 885–899 889Cost-minimization by the household implies that nominal consumption expenditure equals Ptct , where Pt Z 1 0 P 1gt it di !1=ð1gt Þ is the overall price index. The household maximizes utility from consumption, E0 X1 t0 bt logðctÞ, subject to the following period budget constraint: ð1þ it1Þ Bt1 Pt þ Z 1 0 nit Z zR it witðzÞ gðzÞ 1 GðzRitÞ dz diþ ð1 ntÞrBwþPt ct þ Bt Pt þ tt , where Bt1 are holdings of one-period nominal bonds, it is the nominal interest rate, w R zR...

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...al costs. This, however, has a small effect on inflation volatility, because Euro Area data favor model parameterizations in which hiring costs are small. The analysis of this paper is conducted using a search and matching model of the labor market, which is only one possible way of analyzing the effect of labor market reforms on inflation dynamics. It would be interesting to establish whether the same results carry over to other environments such as the search-island model (Lucas and Prescott, 1974; Ljungqvist and Sargent, 1998, 2006), the insider–outsider model (Blanchard and Summers, 1986; Lindbeck and Snower, 1988), or a model where firms fire workers only in certain states (Bentolila and Bertola, 1990). Within the realm of the search and matching framework, an important extension of the analysis presented here would be to incorporate stickiness in real wages, which is likely to interact with labor market policies in shaping the behavior of inflation. This will prove to be a difficult task, however, because of the theoretical requirement known as the ‘‘Barro critique’’, namely that wage stickiness should not lead to the destruction of jobs that command a positive joint surplus. Hall (2005) derived the a...

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...ring component of real marginal costs. This, however, has a small effect on inflation volatility, because Euro Area data favor model parameterizations in which hiring costs are small. The analysis of this paper is conducted using a search and matching model of the labor market, which is only one possible way of analyzing the effect of labor market reforms on inflation dynamics. It would be interesting to establish whether the same results carry over to other environments such as the search-island model (Lucas and Prescott, 1974; Ljungqvist and Sargent, 1998, 2006), the insider–outsider model (Blanchard and Summers, 1986; Lindbeck and Snower, 1988), or a model where firms fire workers only in certain states (Bentolila and Bertola, 1990). Within the realm of the search and matching framework, an important extension of the analysis presented here would be to incorporate stickiness in real wages, which is likely to interact with labor market policies in shaping the behavior of inflation. This will prove to be a difficult task, however, because of the theoretical requirement known as the ‘‘Barro critique’’, namely that wage stickiness should not lead to the destruction of jobs that command a positive joint surplu...

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...on. Changes in unemployment benefits can have important effects on the volatility of the hiring component of real marginal costs. This, however, has a small effect on inflation volatility, because Euro Area data favor model parameterizations in which hiring costs are small. The analysis of this paper is conducted using a search and matching model of the labor market, which is only one possible way of analyzing the effect of labor market reforms on inflation dynamics. It would be interesting to establish whether the same results carry over to other environments such as the search-island model (Lucas and Prescott, 1974; Ljungqvist and Sargent, 1998, 2006), the insider–outsider model (Blanchard and Summers, 1986; Lindbeck and Snower, 1988), or a model where firms fire workers only in certain states (Bentolila and Bertola, 1990). Within the realm of the search and matching framework, an important extension of the analysis presented here would be to incorporate stickiness in real wages, which is likely to interact with labor market policies in shaping the behavior of inflation. This will prove to be a difficult task, however, because of the theoretical requirement known as the ‘‘Barro critique’’, namely that w...

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... m t iidð0;smÞ. 2.2. Households There exists a large, representative household with a measure-one continuum of members. A fraction nt R 1 0 nit di of its members are employed. The remaining members are engaged in home production, receive unemployment benefits and search for jobs. All members pool their resources so as to ensure equal consumption.6 The household consumes the following basket of differentiated goods, ct Z 1 0 c ðgt1Þ=gt it di !gt=ðgt1Þ . 6 The assumption of perfect insurance of unemployment risk is standard in the search and matching literature. See e.g. Merz (1995) and Andolfatto (1996). ARTICLE IN PRESS C. Thomas, F. Zanetti / Journal of Monetary Economics 56 (2009) 885–899 889Cost-minimization by the household implies that nominal consumption expenditure equals Ptct , where Pt Z 1 0 P 1gt it di !1=ð1gt Þ is the overall price index. The household maximizes utility from consumption, E0 X1 t0 bt logðctÞ, subject to the following period budget constraint: ð1þ it1Þ Bt1 Pt þ Z 1 0 nit Z zR it witðzÞ gðzÞ 1 GðzRitÞ dz diþ ð1 ntÞrBwþPt ct þ Bt Pt þ tt , where Bt1 are holdings of one-period nominal bonds, it is the nominal interest rate, w R zR wðzÞðgðzÞ=1 Gðz RÞÞd...

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...a on inflation, unit labor costs and several indicators of labor market activity in order to estimate the New Keynesian Phillips curve that arises in models with search frictions.3 In such models, the cost of hiring workers adds to the usual wage costs as a determinant of marginal costs. Our model features a similar expression for marginal costs, with the addition of a firing cost component. Krause et al. (2008)2 See for instance Bentolila and Bertola (1990), Yashiv (2004), Layard et al. (2005) and Ljungqvist and Sargent (2006). 3 Their empirical implementation is based on theoretical work by Krause and Lubik (2007), Blanchard and Gali (2009) and Rotemberg (2006). See also Ravenna and Walsh (2008). ARTICLE IN PRESS C. Thomas, F. Zanetti / Journal of Monetary Economics 56 (2009) 885–899 887find that hiring costs make a small contribution to real marginal costs and hence to inflation, which points in the same direction as our results for the Euro Area.4 The remainder of this paper is organized as follows. Section 2 lays out the model. Section 3 parameterizes the model to Euro Area data, using both calibration and maximum likelihood estimation. It then assesses the model’s ability to match the data and anal...

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...r costs and several indicators of labor market activity in order to estimate the New Keynesian Phillips curve that arises in models with search frictions.3 In such models, the cost of hiring workers adds to the usual wage costs as a determinant of marginal costs. Our model features a similar expression for marginal costs, with the addition of a firing cost component. Krause et al. (2008)2 See for instance Bentolila and Bertola (1990), Yashiv (2004), Layard et al. (2005) and Ljungqvist and Sargent (2006). 3 Their empirical implementation is based on theoretical work by Krause and Lubik (2007), Blanchard and Gali (2009) and Rotemberg (2006). See also Ravenna and Walsh (2008). ARTICLE IN PRESS C. Thomas, F. Zanetti / Journal of Monetary Economics 56 (2009) 885–899 887find that hiring costs make a small contribution to real marginal costs and hence to inflation, which points in the same direction as our results for the Euro Area.4 The remainder of this paper is organized as follows. Section 2 lays out the model. Section 3 parameterizes the model to Euro Area data, using both calibration and maximum likelihood estimation. It then assesses the model’s ability to match the data and analyzes some of its transmissi...

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...y maximum likelihood. We find that the likelihood of the model is highest for sz 0:20 and choose this value as our baseline.16 Our quantitative conclusions, however, are not sensitive to this parameter, as is shown later. Given the values of mz, sz and l n, the reservation productivity equals zR F1ðln;mz;szÞ 0:65, where Fðz;mz;szÞ is the cdf of the lognormal distribution. The average idiosyncratic productivity equals z R zR zðgðzÞ=1 Gðz RÞÞdz 1:03. In the steady state, Eqs. (16) and (17) and the cross-sectional average of Eq. (14)12 Den Haan et al. (2000) set ln=l to 32%, whereas Pissarides (2007) estimates that endogenous separations account for 60% of all separations. The midpoint of these estimates is 46%. 13 Our choice of x does not affect our quantitative conclusions. Robustness results in this respect are available upon request from the authors. 14 See e.g. Den Haan et al. (2000), Walsh (2005), Krause and Lubik (2007) and Trigari (2009). 15 For values of sz lower than 0.18, the model’s steady-state equations imply negative values for w, which violates the non-negativity constraint on this parameter. This is why we choose 0.20 as the lowest value in the grid. 16 While it would be ...

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...zes the model to Euro Area data, using both calibration and maximum likelihood estimation. It then assesses the model’s ability to match the data and analyzes some of its transmission mechanisms. Section 4 presents the baseline results regarding the effect of labor market reform on price stability, and performs robustness exercises. Section 5 concludes. 2. Model This section presents a New Keynesian model with search and matching frictions and endogenous job destruction a la Mortensen and Pissarides (1994). Our framework is therefore similar to those of Walsh (2005), Krause and Lubik (2007), Trigari (2009), Campolmi and Faia (2006) and Zanetti (2007). The model economy is populated by four types of agents: households, firms, a fiscal authority and a monetary authority. Households consist of a large number of members, a fraction of which are unemployed and search for jobs. On the other side of the labor market, firms post a number of vacancies. Unemployed workers and vacancies, which are denoted by ut and vt , respectively, meet in the so-called matching function, mðvt ;utÞ. Normalizing the size of the labor force to 1, ut also represents the unemployment rate. Under the assumption of constant r...

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...ays out the model. Section 3 parameterizes the model to Euro Area data, using both calibration and maximum likelihood estimation. It then assesses the model’s ability to match the data and analyzes some of its transmission mechanisms. Section 4 presents the baseline results regarding the effect of labor market reform on price stability, and performs robustness exercises. Section 5 concludes. 2. Model This section presents a New Keynesian model with search and matching frictions and endogenous job destruction a la Mortensen and Pissarides (1994). Our framework is therefore similar to those of Walsh (2005), Krause and Lubik (2007), Trigari (2009), Campolmi and Faia (2006) and Zanetti (2007). The model economy is populated by four types of agents: households, firms, a fiscal authority and a monetary authority. Households consist of a large number of members, a fraction of which are unemployed and search for jobs. On the other side of the labor market, firms post a number of vacancies. Unemployed workers and vacancies, which are denoted by ut and vt , respectively, meet in the so-called matching function, mðvt ;utÞ. Normalizing the size of the labor force to 1, ut also represents the unemployment...

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... estimated the model using the rate of change of the Harmonized CPI as our measure of inflation (the CPI and the GDP deflator are equivalent in the model). We found the estimation results to be nearly identical. 20 Real price rigidities arise in situations in which individual marginal cost curves are upward-sloping, which is not the case in the present framework. Such rigidities have the effect of slowing price adjustment for a given average frequency of price adjustment. Equivalently, they reduce the amount of price stickiness that is needed to match inflation dynamics. On this question, see Altig et al. (2004) or Woodford (2005). ARTICLE IN PRESS 0 10 20 30 40 –0.03 –0.02 –0.01 0 0.01 0.02 0.03 output fitted data 0 10 20 30 40 –0.015 –0.01 –0.005 0 0.005 0.01 0.015 0.02 employment 0 10 20 30 40 –0.015 –0.01 –0.005 0 0.005 0.01 0.015 year–on–year inflation 0 10 20 30 40 –0.015 –0.01 –0.005 0 0.005 0.01 0.015 0.02 nominal interest rates Fig. 1. Data versus fitted values of the observable variables. Data description: GDP at constant prices, total domestic employment, year-on-year growth rate of GDP deflator and 3-month Euribor; source: ECB Statistical Data Warehouse; sample period: 1997:Q1–2007:Q4. No...

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...idð0;sAÞ. 2.1.1. Cost minimization Subject to Eqs. (1) and (2), the firm minimizes its production costs E0 X1 t0 b0;t nit Z zR it witðzÞ gðzÞ 1 GðzRitÞ dzþ wvit þ GðzRitÞð1 l x Þnit1 þ qðytÞvit F ( ) , 4 They find, however, that search frictions reduce the role of backward-looking price setting for generating inflation persistence. 5 We therefore assume that workers hired in period t start producing in the same period. This assumption has become standard in recent DSGE applications of the search and matching framework that assume a quarterly frequency, such as Blanchard and Gali (2009), Gertler et al. (2008), Sala et al. (2008) and Krause et al. (2008). ARTICLE IN PRESS C. Thomas, F. Zanetti / Journal of Monetary Economics 56 (2009) 885–899888where bs;t b tscs=ct is the stochastic discount factor between any two periods s and t ðsotÞ, b is the subjective discount factor, witðzÞ is the real wage paid to the worker with idiosyncratic productivity z (to be determined later), w40 is the real cost of posting a vacancy and F is the real firing cost paid by the firm for each endogenous separation. Let fit and jit denote the Lagrange multipliers associated to Eqs. (1) and (2), respectively. Therefore,...

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...) imply that Atnit R zRt zgðzÞ=ð1 GðzRt ÞÞdz ðPit=PtÞ gt yt , that is, each firm’s supply must meet its own demand. Integrating this condition across all firms yields the following: Atnt Z zRt z gðzÞ 1 GðzRt Þ dz ytDt , (21) where Dt R 1 0 ðPit=PtÞ gt di is a measure of price dispersion with law of motion11 Dt ð1 dÞ Pt Pt gt þ d Pt Pt1 gt Dt1. (22) Finally, the price level evolves according to Pt dP 1gt t1 þ ð1 dÞðP t Þ 1gt 1=ð1gt Þ. (23)9 For supportive evidence on the plausibility of the Taylor rule as a description of actual ECB monetary policy, see e.g. Christoffel et al. (2008), Rabanal (2009) and Christoffel and Kuester (2009). 10 This does not mean, however, that all firms are symmetric in equilibrium. Given the price dispersion created by staggered price adjustment, firms will also differ in their output levels, yit , the size of their workforce, nit , and their number of vacancies, vit . 11 See e.g. Yun (1996). ARTICLE IN PRESS C. Thomas, F. Zanetti / Journal of Monetary Economics 56 (2009) 885–899 891Equilibrium in this economy is defined as the path fit ; ct ; yt ;nt ;ut ;Dt ; zRt ; yt ;jt ;vt ; Pt ; P t g 1 t0 that satisfies Eq. (9) (without i subscripts),...

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...z ðPit=PtÞ gt yt , that is, each firm’s supply must meet its own demand. Integrating this condition across all firms yields the following: Atnt Z zRt z gðzÞ 1 GðzRt Þ dz ytDt , (21) where Dt R 1 0 ðPit=PtÞ gt di is a measure of price dispersion with law of motion11 Dt ð1 dÞ Pt Pt gt þ d Pt Pt1 gt Dt1. (22) Finally, the price level evolves according to Pt dP 1gt t1 þ ð1 dÞðP t Þ 1gt 1=ð1gt Þ. (23)9 For supportive evidence on the plausibility of the Taylor rule as a description of actual ECB monetary policy, see e.g. Christoffel et al. (2008), Rabanal (2009) and Christoffel and Kuester (2009). 10 This does not mean, however, that all firms are symmetric in equilibrium. Given the price dispersion created by staggered price adjustment, firms will also differ in their output levels, yit , the size of their workforce, nit , and their number of vacancies, vit . 11 See e.g. Yun (1996). ARTICLE IN PRESS C. Thomas, F. Zanetti / Journal of Monetary Economics 56 (2009) 885–899 891Equilibrium in this economy is defined as the path fit ; ct ; yt ;nt ;ut ;Dt ; zRt ; yt ;jt ;vt ; Pt ; P t g 1 t0 that satisfies Eq. (9) (without i subscripts), (10), (15)–(23), and the relationship vt ytut , ...

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... of labor market activity in order to estimate the New Keynesian Phillips curve that arises in models with search frictions.3 In such models, the cost of hiring workers adds to the usual wage costs as a determinant of marginal costs. Our model features a similar expression for marginal costs, with the addition of a firing cost component. Krause et al. (2008)2 See for instance Bentolila and Bertola (1990), Yashiv (2004), Layard et al. (2005) and Ljungqvist and Sargent (2006). 3 Their empirical implementation is based on theoretical work by Krause and Lubik (2007), Blanchard and Gali (2009) and Rotemberg (2006). See also Ravenna and Walsh (2008). ARTICLE IN PRESS C. Thomas, F. Zanetti / Journal of Monetary Economics 56 (2009) 885–899 887find that hiring costs make a small contribution to real marginal costs and hence to inflation, which points in the same direction as our results for the Euro Area.4 The remainder of this paper is organized as follows. Section 2 lays out the model. Section 3 parameterizes the model to Euro Area data, using both calibration and maximum likelihood estimation. It then assesses the model’s ability to match the data and analyzes some of its transmission mechanisms. Sectio...

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...) where bxt;tþ1 bt;tþ1ð1 l x Þ. The worker therefore receives a weighted average of her outside option, wt , and the sum of her contribution to current profits and a firing-cost component. Firing costs affect wage payments in the following way: the7 Notice that the worker’s surplus does not depend on F. As is well known, those components of the cost of firing a worker that represent a transfer from the firm to the worker (such as severance payments) leave the joint match surplus unaffected and therefore have no effect on job creation and job destruction under Nash wage bargaining; see e.g. Mortensen and Pissarides (2003). The parameter F therefore includes only the non-transfer components of firing costs, such as legal costs, sanctions for delayed payments, as well as foregone health insurance and social security contributions. 8 Since the outside option for the firm in wage negotiations is firing the worker and paying firing costs, the firm’s surplus equals JitðzÞ ðFÞ JitðzÞ þ F. See e.g. Mortensen and Pissarides (2003). ARTICLE IN PRESS C. Thomas, F. Zanetti / Journal of Monetary Economics 56 (2009) 885–899890firm rewards the worker for the saving in firing costs today, but penalizes her for the fact t...

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...ing the rate of change of the Harmonized CPI as our measure of inflation (the CPI and the GDP deflator are equivalent in the model). We found the estimation results to be nearly identical. 20 Real price rigidities arise in situations in which individual marginal cost curves are upward-sloping, which is not the case in the present framework. Such rigidities have the effect of slowing price adjustment for a given average frequency of price adjustment. Equivalently, they reduce the amount of price stickiness that is needed to match inflation dynamics. On this question, see Altig et al. (2004) or Woodford (2005). ARTICLE IN PRESS 0 10 20 30 40 –0.03 –0.02 –0.01 0 0.01 0.02 0.03 output fitted data 0 10 20 30 40 –0.015 –0.01 –0.005 0 0.005 0.01 0.015 0.02 employment 0 10 20 30 40 –0.015 –0.01 –0.005 0 0.005 0.01 0.015 year–on–year inflation 0 10 20 30 40 –0.015 –0.01 –0.005 0 0.005 0.01 0.015 0.02 nominal interest rates Fig. 1. Data versus fitted values of the observable variables. Data description: GDP at constant prices, total domestic employment, year-on-year growth rate of GDP deflator and 3-month Euribor; source: ECB Statistical Data Warehouse; sample period: 1997:Q1–2007:Q4. Nominal interest rate...

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...ctions in the labor market on inflation dynamics. In particular, Krause et al. (2008) use US data on inflation, unit labor costs and several indicators of labor market activity in order to estimate the New Keynesian Phillips curve that arises in models with search frictions.3 In such models, the cost of hiring workers adds to the usual wage costs as a determinant of marginal costs. Our model features a similar expression for marginal costs, with the addition of a firing cost component. Krause et al. (2008)2 See for instance Bentolila and Bertola (1990), Yashiv (2004), Layard et al. (2005) and Ljungqvist and Sargent (2006). 3 Their empirical implementation is based on theoretical work by Krause and Lubik (2007), Blanchard and Gali (2009) and Rotemberg (2006). See also Ravenna and Walsh (2008). ARTICLE IN PRESS C. Thomas, F. Zanetti / Journal of Monetary Economics 56 (2009) 885–899 887find that hiring costs make a small contribution to real marginal costs and hence to inflation, which points in the same direction as our results for the Euro Area.4 The remainder of this paper is organized as follows. Section 2 lays out the model. Section 3 parameterizes the model to Euro Area data, using both calibration and maxi...

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...n order to estimate the New Keynesian Phillips curve that arises in models with search frictions.3 In such models, the cost of hiring workers adds to the usual wage costs as a determinant of marginal costs. Our model features a similar expression for marginal costs, with the addition of a firing cost component. Krause et al. (2008)2 See for instance Bentolila and Bertola (1990), Yashiv (2004), Layard et al. (2005) and Ljungqvist and Sargent (2006). 3 Their empirical implementation is based on theoretical work by Krause and Lubik (2007), Blanchard and Gali (2009) and Rotemberg (2006). See also Ravenna and Walsh (2008). ARTICLE IN PRESS C. Thomas, F. Zanetti / Journal of Monetary Economics 56 (2009) 885–899 887find that hiring costs make a small contribution to real marginal costs and hence to inflation, which points in the same direction as our results for the Euro Area.4 The remainder of this paper is organized as follows. Section 2 lays out the model. Section 3 parameterizes the model to Euro Area data, using both calibration and maximum likelihood estimation. It then assesses the model’s ability to match the data and analyzes some of its transmission mechanisms. Section 4 presents the baseline results r...

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...is very small. As a result, a certain percentage change in the volatility of the firing component has a very small absolute effect on inflation volatility. In the case of UB, the data favor model parameterizations in which hiring costs are small, which is necessary in order to match observed employment fluctuations. Since the hiring component contributes very little to inflation dynamics, even large percentage changes in the volatility of hiring costs will have again small absolute effects on inflation volatility. Our analysis is closely related to earlier work by Campolmi and Faia (2006) and Zanetti (2007). Campolmi and Faia (2006) document a negative relationship between the replacement ratio of unemployment benefits and inflation volatility across Euro Area members. They subsequently build a two-country model of a currency union characterized by matching frictions and nominal price rigidities, and show that their model is able to reproduce the observed relationship between unemployment benefits and inflation volatility. Our model abstracts from international spill-overs, by treating the Euro Area as a single country, and extends the analysis of labor market policies by also considering the ef...

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...gðzÞ=ð1 GðzRt ÞÞdz ðPit=PtÞ gt yt , that is, each firm’s supply must meet its own demand. Integrating this condition across all firms yields the following: Atnt Z zRt z gðzÞ 1 GðzRt Þ dz ytDt , (21) where Dt R 1 0 ðPit=PtÞ gt di is a measure of price dispersion with law of motion11 Dt ð1 dÞ Pt Pt gt þ d Pt Pt1 gt Dt1. (22) Finally, the price level evolves according to Pt dP 1gt t1 þ ð1 dÞðP t Þ 1gt 1=ð1gt Þ. (23)9 For supportive evidence on the plausibility of the Taylor rule as a description of actual ECB monetary policy, see e.g. Christoffel et al. (2008), Rabanal (2009) and Christoffel and Kuester (2009). 10 This does not mean, however, that all firms are symmetric in equilibrium. Given the price dispersion created by staggered price adjustment, firms will also differ in their output levels, yit , the size of their workforce, nit , and their number of vacancies, vit . 11 See e.g. Yun (1996). ARTICLE IN PRESS C. Thomas, F. Zanetti / Journal of Monetary Economics 56 (2009) 885–899 891Equilibrium in this economy is defined as the path fit ; ct ; yt ;nt ;ut ;Dt ; zRt ; yt ;jt ;vt ; Pt ; P t g 1 t0 that satisfies Eq. (9) (without i subscripts), (10), (15)–(23)...

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... costs to inflation dynamics is very small. As a result, a certain percentage change in the volatility of the firing component has a very small absolute effect on inflation volatility. In the case of UB, the data favor model parameterizations in which hiring costs are small, which is necessary in order to match observed employment fluctuations. Since the hiring component contributes very little to inflation dynamics, even large percentage changes in the volatility of hiring costs will have again small absolute effects on inflation volatility. Our analysis is closely related to earlier work by Campolmi and Faia (2006) and Zanetti (2007). Campolmi and Faia (2006) document a negative relationship between the replacement ratio of unemployment benefits and inflation volatility across Euro Area members. They subsequently build a two-country model of a currency union characterized by matching frictions and nominal price rigidities, and show that their model is able to reproduce the observed relationship between unemployment benefits and inflation volatility. Our model abstracts from international spill-overs, by treating the Euro Area as a single country, and extends the analysis of labor market policies by also...

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...h that analyzes the effect of search frictions in the labor market on inflation dynamics. In particular, Krause et al. (2008) use US data on inflation, unit labor costs and several indicators of labor market activity in order to estimate the New Keynesian Phillips curve that arises in models with search frictions.3 In such models, the cost of hiring workers adds to the usual wage costs as a determinant of marginal costs. Our model features a similar expression for marginal costs, with the addition of a firing cost component. Krause et al. (2008)2 See for instance Bentolila and Bertola (1990), Yashiv (2004), Layard et al. (2005) and Ljungqvist and Sargent (2006). 3 Their empirical implementation is based on theoretical work by Krause and Lubik (2007), Blanchard and Gali (2009) and Rotemberg (2006). See also Ravenna and Walsh (2008). ARTICLE IN PRESS C. Thomas, F. Zanetti / Journal of Monetary Economics 56 (2009) 885–899 887find that hiring costs make a small contribution to real marginal costs and hence to inflation, which points in the same direction as our results for the Euro Area.4 The remainder of this paper is organized as follows. Section 2 lays out the model. Section 3 parameterizes the ...