Paolo Bontempo (FAU Erlangen-Nürnberg)
This paper studies the macroeconomic effects of trend inflation in a New Keynesian model featuring a labor market with search and matching frictions. The work examines how inflation in steady-state influences labor market dynamics and output, comparing three model variants: a Walrasian labor market, a frictional labor market with fixed labor force, and a frictional labor market with endogenous labor force participation. In a frictional labor market, trend inflation reduces the real price at which firms sell their initial good, diminishing their incentives to post vacancies and increasing unemployment. However, when labor supply is endogenous, inflation also induces households to offer more labor, partially offsetting its negative effects on production by increasing the absolute number of employed workers. In contrast, when the labor force is fixed, employment falls, amplifying the decline in output. The analysis continues with the simulation of a permanent disinflationary policy and show that economies with flexible labor supply converge more quickly to the new equilibrium and experience lower sacrifice ratios. The results highlight the importance of accounting for endogenous labor participation in evaluating the costs of trend inflation in models with labor market frictions.