Unemployment in an Estimated New Keynesian Model
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We reformulate the Smets-Wouters (2007) framework by embedding the theory of unemployment proposed in Galí (2011b, 2011c). We estimate the resulting model using postwar US data, while treating the unemployment rate as an additional observable variable. Our approach overcomes the lack of identification of wage markup and labor supply shocks highlighted by Chari, Kehoe, and McGrattan (2008) in their criticism of New Keynesian models, and allows us to estimate a "correct" measure of the output gap. In addition, the estimated model can be used to analyze the sources of unemployment fluctuations.
We have benefited from comments by Larry Christiano, Marco del Negro, Keith Kuester, Richard Rogerson, Carlos Thomas, and participants at the NBER Summer Institute, SED Conference (Montréal), Banque de France, Harvard, EUI (Florence), Bank of Cyprus, CREI-UPF, ECB, Leuven, Insead, PSE, Carlos III and IMF. Galí acknowledges the financial support from the European Research Council through an Advanced Grant (Project Reference #229650).