Wage dynamics, Unemployment, and Inflation: Enhancing 4GM Semi-Structural Model

We extend the semi-structural model for monetary policy analysis and forecasting in Colombia, the 4GM model (González et al., 2020), by integrating labor market dynamics into its specification. We incorporate four key mechanisms: (1) wage-price feedback and its effects on marginal costs; (2) the impact of the NAIRU on potential output; (3) Okun’s law to connect cyclical unemployment to the output gap; and (4) the impact of real wages and unemployment on aggregate demand. Our model adds to the baseline 4GM model interactions between goods and labor markets, which affect the transmission of the monetary policy. Focusing on Colombia, a country with a labor market characterized by rigidities and persistently high unemployment, we demonstrate how wage dynamics and labor market tightness amplify inflationary pressures and delay adjustment. Our model aids in disentangling supply and demand shocks, particularly during crises (e.g., the pandemic), when labor market idiosyncrasies distort wage and inflation trends