Labor markets and monetary policy: A new-Keynesian model with unemployement

We construct a utility-based model of fluctuations, with nominal rigidities andunemployment, and draw its implications for the unemployment-inflation trade-off and for the conduct of monetary policy.We proceed in two steps. We first leave nominal rigidities aside. We show that,under a standard utility specification, productivity shocks have no effect onunemployment in the constrained efficient allocation. We then focus on theimplications of alternative real wage setting mechanisms for fluctuations in un-employment. We show the role of labor market frictions and real wage rigiditiesin determining the effects of productivity shocks on unemployment.We then introduce nominal rigidities in the form of staggered price setting byfirms. We derive the relation between inflation and unemployment and discusshow it is influenced by the presence of labor market frictions and real wagerigidities. We show the nature of the tradeoff between inflation and unemployment stabilization, and its dependence on labor market characteristics. We draw the implications for optimal monetary policy.