On the Long-Run Unemployment, Inflation, and Volatility

Abstract

This paper revisits the relationship between unemployment and inflation in the long-run through the lens of a New-Keynesian model augmented with downward nominal wage rigidity (DNWR). It finds that when the labor market is affected by DNWR, this relationship goes beyond the tradeoff between the first moments of unemployment and inflation provided by the short-run Phillips curve. Higher volatility in inflation raises unemployment at the low-frequency. Increased volatility in inflation makes nominal wages more volatile but the downward rigidity constrains nominal wages from falling. Unemployment is therefore more likely to increase above the natural level to guarantee the labor market equilibrium. The theoretical findings are robust to different formalizations of DNWR and to workers that are assumed as forward-looking of DNWR. Panel regressions test the positive long-run co-movement between unemployment and inflation volatility using the data from the OECD countries. The sensitivity analysis confirms the evidence for several controls and regression specifications.