George Alogoskoufis and Stelios Giannoulakis

Working Paper no. 11-23, Department of Economics, Athens University of Economics and Business

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This paper puts forward an analytically tractable dynamic stochastic general equilibrium model, with both labor and product market frictions. Frictions in the labor market arise from the power of labor market insiders to periodically pre-set nominal wages, without full current infor- mation. Product market frictions arise from monopolistic competition and staggered pricing.

The model results in a dynamic expectations-augmented New Keynesian Phillips Curve (DEANKPC) that transcends the main limitations of the benchmark and hybrid NKPCs based on staggered pricing, as: (i) it is expressed in terms of unanticipated inflation since current inflation depends on prior expectations about its level; (ii) unemployment (output) and inflation persistence are endogenous; and (iii) the divine coincidence between the stabilization of inflation and employment (output) does not apply, rendering a Taylor-type interest rate rule optimal.

We evaluate the dynamic properties of the model and the empirical validity of the DEANKPC, in comparison with those of the benchmark NK model, through a simulation exercise and an empirical application for the Euro Area.

© George Alogoskoufis