Santa Cruz Center for International Economics

In this paper, a simple search model of the labor market is combined with sticky prices to investigate the dynamic response of the economy to nominal interest rate shocks. The framework allows the respective roles of labor market search, nominal price rigidities, and policy inertia in accounting for the impact of monetary policy shocks to be studied. Labor market rigidities introduced by the process of matching job seekers with job vacancies amplify the real impact and reduce the inflation impact of a monetary policy shock. As a result, significantly less price rigidity is required; for example, the dynamic response of output and inflation in the new Keynesian model with a Walrasian labor market and only 15% of firms optimally adjusting prices each period can be replicated in the labor market search model when a more realistic 50% of firms optimally adjust their price each period.