Propagation Mechanism in the New-Keynesian Model with Labor Adjustment Costs

Calvo nominal rigidities are well known to enhance the monetary transmission mechanism in dynamic stochastic general equilibrium (DSGE) models. However, this class of models gives rise to certain anomalies, including excessively high volatilities and countercyclical productivity. In addition, much of the New-Keynesian literature has miss-calibrated the propagation-determining parameter of the Calvo formulation. This paper finds that using proper parameterization does not eliminate the anomalies instead it lowers persistence. In light of this, labor adjustment costs are added to the DSGE model with nominal wage rigidities and shown to overcome the shortcomings by yielding reasonable volatilities and a positive correlation between output and productivity, and at the same time increasing persistence.