The Inflation-Output Tradeoff: Which Type of Labor Market Rigidity Is to Be Blamed?

In the standard New Keynesian sticky price model the central bank faces no contradiction between the stabilization of inflation and the stabilization of the welfare relevant output gap after a productivity shock hits the economy. When the standard model is enhanced by real wage rigidities or labor turnover costs, an endogenous short-run inflation-output tradeoff arises. This paper compares the implications of the two labor market rigidities. It argues that economists and policymakers alike should pay more attention to labor turnover costs for the following reasons. First, a model with labor turnover costs generates impulse response functions that are more in line with the empirical evidence than those of a model with real wage rigidities. Second, labor turnover costs are the dominant source for the inflation-output tradeoff when both rigidities are present in the model. And finally, there is stronger empirical evidence for the existence of labor turnover costs than for real wage rigidities.