Federal Reserve Board and CEPR‡

Preliminary and incomplete We assess the empirical relevance for inflation dynamics of accounting for the presence of search frictions in the labor market. The New Keynesian Phillips curve explains inflation dynamics as being mainly driven by current and ex-pected future marginal costs. Recent empirical research has emphasized differ-ent measures of real marginal costs to be consistent with observed inflation per-sistence. We argue that, allowing for search frictions in the labor market, real marginal cost should also incorporate the cost of generating and maintaining long-term employment relationships, along with conventional measures, such as real unit labor costs. In order to construct a synthetic measure of real marginal costs, we use newly available labor market data on worker finding and separa-tion rates that reflect firing and hiring costs to the firm. We then estimate a New Keynesian Phillips curve using structural econometric techniques. ∗We thank Robert Shimer, Ryan Michaels, and Shigeru Fujita for kindly making their data available to us. The views in this paper are those of the authors and not necessarily those of the Deutsche Bundesbank, the Federal Reserve Bank of Richmond, or the Federal Reserve System