This paper extends the baseline open economy DSGE model presented in Elbourne et al. (2009)
with labour market interactions in which a meaningful role for unemployment has been reserved.
To allow for policy having real effects, the dominant modelling paradigm of infinitely lived
representative households has been discarded. Instead, overlapping generations households are
used. The modelling device for the labour market is a search and matching framework in the
spirit of Mortensen and Pissarides (1994), in which wages are determined through Nash
bargaining and characterized by the right-to-manage assumption. The contribution of this paper
is that in the described set up we also allow for endogenous labour market participation, which
facilitates the calibration of the model. The functioning of the model has been illustrated by a
policy relevant example considering the effects of changing the replacement rate on the
economy.