In this paper, we explore the role of labor markets for monetary policy in the euro area in a New
Keynesian model in which labor markets are characterized by search and matching frictions.
We first investigate to which extent a more flexible labor market would alter the business cycle
behavior and the transmission of monetary policy. We find that while a lower degree of wage
rigidity makes monetary policy more effective, i.e. a monetary policy shock transmits faster
onto inflation, the importance of other labor market rigidities for the transmission of shocks is
rather limited. Second, having estimated the model by Bayesian techniques we analyze to which
extent labor market shocks, such as disturbances in the vacancy posting process, shocks to the
separation rate and variations in bargaining power are important determinants of business cycle
fluctuations. Our results point primarily towards disturbances in the bargaining process as a
significant contributor to inflation and output fluctuations. In sum, the paper supports current
central bank practice which appears to put considerable effort into monitoring euro area wage
dynamics and which appears to treat some of the other labor market information as less important
for monetary policy.