This paper puts forward an alternative “new Keynesian” dynamic stochastic general equilibrium model of aggregate fluctuations. The model is characterized by one period nominal wage contracts and endogenous persistence of deviations of unemployment from its natural rate. Aggregate fluctuations are analyzed under both a Taylor nominal interest rate rule and under the assumption of optimal discretionary monetary policy. Under both types of monetary policy, the persistence of unemployment results in persistent inflation as the central bank responds to deviations of unemployment from its natural rate. Econometric evidence from the United States since the 1890s cannot reject the main predictions of the model.
Keywords: aggregate fluctuations, unemployment persistence, inflation, monetary policy, insiders outsiders, natural rate
JEL Classification: E3, E4, E5