This paper provides a new explanation of why inflation is sluggish in response to aggregate demand shocks and why aggregate output changes as result of such shocks. We argue that these phenomena are related to between inputs and outputs in the process, production lags for short. The broad intuition is that activities in a modern economy are interconnected through complex input-output relations, with within individual firms, and that it takes considerable time for cost and price changes to penetrate the entire input-output system. Our analysis provides a rationale for a prolonged inverse relation between inflation and unemployment. The paper suggests that the interaction of inflation persistence and unemployment persistence may offer a possible explanation of high and prolonged European unemployment. (This abstract was borrowed from another version of this item.)

economic policy ; unemployment

We present a theory of involuntary unemployment which explains why the unemployed workers ("outsiders") are unable or unwilling to find jobs even though they are prepared to work for less than the prevailing wages of incumbent workers ("insiders"). The outsiders do not underbid the insiders since, were they to do so, the insiders would withdraw cooperation from them and make their work unpleasant (that is, "harass" them), thereby reducing the productivity and increasing the reservation wages of the underbidders. The resulting labor turnover costs create economic rent which the insiders tap in wage setting and, as a result, involuntary unemployment may arise.