Assessing the empirical relevance of labor frictions to business cycle fluctuations

This paper describes a DSGE model augmented with labor frictions, namely: indivisible labor, predetermined employment and adjustment costs. This improves the fit to the data as shown by a higher log marginal likelihood and closer match to key business cycle statistics. The labor frictions introduced are relevant for model dynamics and economic policy: the effect of TFP shocks on most macroeconomic variables is substantially mitigated; fiscal policy leads to a greater crowding out of private sector activity and monetary policy has a lower impact on output. Labor frictions also provide a better match to impulse response functions from VAR models.