The canonical new Keynesian Phillips Curve has become a standard component of models designed for monetary policy analysis. However, in the basic new Keynesian model, there is no unemployment, all variation in labor input occurs along the intensive hours margin, and the driving variable for inflation depends on workers' marginal rates of substitution between leisure and consumption. In this paper, we incorporate a theory of unemployment into the new Keynesian theory of inflation and show how a measure of labor market tightness is the driving variable for inflation. We show how the elasticity of inflation with respect to labor market tightness depends on structural characteristics of the labor market such as the matching technology that pairs vacancies with unemployed workers. We test the empirical implications of the model using U.S. data.
