Inflation Dynamics and Labor Adjustments in Japan: A Bayesian DSGE Approach

Many studies of inflation dynamics assume that in the presence of competitive labor markets firms adjust labor input only at the intensive margin. We consider labor market search and examine the role of the extensive margin for inflation dynamics by estimating three models with distinct labor adjustments. Our Bayesian estimation result shows that the model with only the extensive margin is superior to that with only the intensive one in terms of marginal likelihood. This suggests that the extensive margin may be more important for inflation dynamics in Japan. We also show that introducing the intensive margin into the extensive margin model further improves marginal likelihood. Moreover, we find that real marginal costs in these models with the extensive margin are highly correlated with the Bank of Japan's estimates of the output gap.