The Role of Labor Markets for Euro Area Monetary Policy

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.