DP11639 | The Hiring Frictions and Price Frictions Nexus in Business Cycle Models

Publication Date

11/15/2016

JEL Code(s)

Keyword(s)

Programme Area(s)

Abstract

We study the interactions between hiring frictions and price frictions in business cycle models. We find that these interactions matter in a significant way for business cycle fluctuations and for labor market outcomes. Using a simple DSGE business-cycle model with Diamond-Mortensen-Pisssarides (DMP) elements, we derive two main results. First, introducing hiring frictions into a New Keynesian model offsets the effects of price frictions. As a result, some business cycle outcomes are actually close to the frictionless New Classical-type outcomes; namely, with moderate hiring frictions the response of employment to technology shocks is positive, and the effects of monetary policy shocks are small, if not neutral. Moreover, it generates endogenous wage rigidity. Second, introducing price frictions into a DMP setting generates amplification of employment and unemployment responses to technology shocks, as well as hump-shaped dynamics. Both results arise through the confluence of frictions. We offer an explanation of the mechanisms underlying them.