Unanticipated inflation, unemployment persistence and the New Keynesian Phillips curve

Abstract

This paper puts forward an analytically tractable dynamic stochastic general equilibrium model, with both labour and product market frictions. Frictions in the labour market arise from the power of labour market insiders to periodically preset nominal wages, without full current information. Product market frictions arise from monopolistic competition and staggered pricing. The model results in an insider–outsider New Keynesian Phillips curve (IO-NKPC) that transcends the main limitations of the benchmark and hybrid NKPCs based on staggered pricing, as: (i) it is expressed in terms of unanticipated inflation since current inflation depends on prior expectations about its level; (ii) unemployment (output) and inflation persistence are endogenous; and (iii) the divine coincidence between the stabilization of inflation and employment (output) does not apply, rendering a Taylor-type interest rate rule optimal. Dynamic simulations reveal multifaceted inflation dynamics shaped by the interplay of price stickiness and labour market persistence. An empirical application to the euro area validates the IO-NKPC's superior forecasting performance, highlighting its relevance for understanding inflation dynamics and guiding effective monetary policy design.