The Dynamics of Unemployment and Inflation in New Keynesian Models with Two Labor Margins.

New Keynesian models for which firms unilaterally adjust labor along both the intensive, and extensive margins usually fail to reproduce the volatility of unemployment. In this paper, we show that a marginal wage much more responsive than the average wage to shocks—in accordance with empirical observations—is a crucial mechanism allowing these models to replicate unemployment dynamics. At the same time, the large movements of the marginal wage are consistent with the low volatility of inflation as such movements induce strong strategic complementarities between price setters. [ABSTRACT FROM AUTHOR]