Persistent monetary policy in a model with involuntary unemployment

Abstract In a basic New Keynesian DSGE model with involuntary unemployment, we study the role of labor markets in the transmission of persistent monetary policy shocks that increase households' inflation expectations. The model predicts that, in contrast to the standard nominal interest rate shocks, labor market conditions can affect the outcomes of persistent monetary policy shocks suggesting a trade‐off between inflation and output growth: restricted labor market access leads to higher inflation response with smaller effects on output. Using a vector autoregression analysis, we further provide empirical evidence consistent with the predictions of our theoretical model.