Labour Market Imperfections, "Divine Coincidence" and Volatility of Employment and Inflation

Abstract

The dynamic general equilibrium model with hiring costs presented in this paper delivers involuntary unemployment in the steady state as well as involuntary fluctuations in unemployment. The existence of hiring frictions introduces externalities that, in turn, entail the breakdown of the divine coincidence without assuming real wage rigidity. We are able to show that our model with labour market imperfections outperforms the standard New Keynesian model as for the persistence of responses to monetary shocks. We also attempt an analysis of the volatility of two economies, differing in their degrees of imperfection. It turns out that rigid economies exhibit less unemployment volatility and more inflation volatility than flexible economies.