Real price and wage rigidities with matching frictions

Frictional unemployment means that workers, for some time, are a firm-specific factor of production. This paper models the resulting interaction of wage bargaining and price setting at the firm level in a New Keynesian model with labor market matching frictions. Real rigidities arise and the labor share ceases to be a good proxy for marginal costs. The model replicates the impulse responses of an SVAR for U.S. data better than alternatives in which the real rigidities arising at the firm level are absent. In addition, it implies reasonably low degrees of nominal rigidity whereas the alternatives do not. The interaction of wage and price setting at the firm level is important for the macroeconomic dynamics.