DP6810 | Inflation Dynamics with Search Frictions: A Structural Econometric Analysis

Publication Date

25/04/2008

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Abstract

The New Keynesian Phillips curve explains inflation dynamics as being driven by current and expected future real marginal costs. In competitive labour markets, the labour share can serve as a proxy for the latter. In this paper, we study the role of real marginal cost components implied by search frictions in the labour market. We construct a measure of real marginal costs by using newly available labour market data on worker finding rates. Over the business cycle, the measure is highly correlated with the labour share. Estimates of the Phillips curve using GMM reveal that the marginal cost measure remains significant, and that inflation dynamics are mainly driven by the forward-looking component. Bayesian estimation of the full New Keynesian model with search frictions helps us disentangle which shocks are driving the economy to generate the observed unit labour cost dynamics. We find that mark-up shocks are the dominant force in labour market fluctuations.