Evaluating the empirical performance of DSGE models: What is the role of search and matching frictions in the labor and capital markets?

A major perspective in explaining the behavior of involuntary unemployment in market economies is to recognize the existence of job search and matching frictions. The workhorse model employed is that of the Diamond-Mortensen-Pissarides (DMP) model. Nevertheless, past research has highlighted several difficulties of the DMP model in empirically matching the actual characteristics of the labor market. I address these shortcomings in two directions. First, within a model enriched with endogenous labor participation and job separation, I evaluate the model's performance in resolving the failure to generate the Beveridge curve in the presence of nominal price rigidity. Second, the standard DMP model limits search and matching frictions to the labor market. It can be argued, however, that the market for physical capital also exhibits such frictions given the pool of unsold inventories as well as used capital that can be resold. Adopting an RBC model with frictional labor and physical capital markets and endogenous labor participation, I evaluate the model's predictions in a context where labor disutility is procyclical under both contemporaneous shocks and news shocks.