Wage Dynamics and Labor Market Dynamics Istvan Konya Hungarian National Bank Michael Krause Deutsche Bundesbank June 6, 2008 Abstract In this paper we examine the ability of the search and matching model to fit important statistics of the labor market. Following Shimer (2005), we first present stylized facts for many Euro Area economies. Then we show that, similarly to the U.S., the basic model is unable to replicate the relative volatility of unemployment found in the data. Second, we present the full, general equilibrium version of the model, and discuss some simple extensions suggested by the literature that may help solving the ”unmployment volatility puzzle”. Finally, we calibrate and simulate the model to see if these extensions are consis- tent with the Euro Area stylized facts. An important difference from previous studies is that in addition to unemployment, we also examine the behavior of wages. Our main finding is that a simple form of real wage rigidity goes a very long way towards solving the puzzle, while other explanations fail to match the low volatility of wages. 1 Introduction Understanding the determinants of real wages is crucial for understanding the dynamics of both the labor market and inflation. A tight labor market is likely to translate into higher wage and cost pressures that accelerate infla- tion. The responsiveness of wages to aggregate labor market conditions itself feeds back on firms’ hiring behavior and thus unemployment. The state of the labor market is therefore important for monetary policy makers’ assessment of inflationary pressures. In this paper, we analyze real wage dynamics from the perspective of search and matching models (Mortensen and Pissarides, 1994) of equilib- rium unemployment. Such models have become the standard for addressing problems of aggregate unemployment. Furthermore, since the model has 1