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and an anonymous referee for helpful comments and suggestions, and Juan Rubio-Ramirez for supplying the Matlab code to compute the finite order VAR representation of a state-space model. Part of this work was prepared while the author was participating in the Banco de España Visiting Fellow program. Support from Banco de España is gratefully acknowledged. The opinions and analyses in the Working Paper Series are the responsibility of the authors and, therefore, do not necessarily coincide with those of the Banco de España or the Eurosystem. Documentos de Trabajo. N.º 0619 2006 The Working Paper Series seeks to disseminate original research in economics and finance. All papers have been anonymously refereed. By publishing these papers, the Banco de España aims to contribute to economic analysis and, in particular, to knowledge of the Spanish economy and its international environment. The opinions and analyses in the Working Paper Series are the responsibility of the authors and, therefore, do not necessarily coincide with those of the Banco de España or the Eurosystem. The Banco de España disseminates its main reports and most of its publications via the INTERNET at the following website: http://www.bde.es. Reproduction for educational and non-commercial purposes is permitted provided that the source is acknowledged.

The canonical new Keynesian Phillips Curve has become a standard component of models designed for monetary policy analysis. However, in the basic new Keynesian model, there is no unemployment, all variation in labor input occurs along the intensive hours margin, and the driving variable for inflation depends on workers' marginal rates of substitution between leisure and consumption. In this paper, we incorporate a theory of unemployment into the new Keynesian theory of inflation and empirically test its implications for inflation dynamics. We show how a traditional Phillips curve linking inflation and unemployment can be derived and how the elasticity of inflation with respect to unemployment depends on structural characteristics of the labor market such as the matching technology that pairs vacancies with unemployed workers. We estimate on US data the Phillips curve generated by the model, and derive the implied marginal cost measure driving inflation dynamics. JEL: E52, E58, J64 1 Introduction The canonical new Keynesian Phillips curve has become a standard component of models designed for monetary policy analysis. Based on the presence of monopolistic competition among individual firms, together with the imposition of stagged price setting, the new Keynesian Phillips curve provides a direct link between the underlying structural parameters characterizing the preferences of individual suppliers of labor and the parameters appearing in the Phillips curve.