Slow Recoveries and Unemployment Traps: Monetary Policy in a Time of Hysteresis*

Abstract

We analyse monetary policy in a model where temporary shocks can permanently scar the economy’s productive capacity. Workers lose skill while unemployed and are costly to retrain, generating multiple steady-state unemployment rates. Following a large shock, unless monetary policy acts aggressively and quickly enough to prevent a significant rise in unemployment, hiring falls to a point where the economy recovers slowly at best – at worst, it falls into a permanent unemployment trap. Monetary policy can only avoid these outcomes if it commits in a timely manner to more accommodative policy in the future. Timely commitment is essential as the effectiveness of monetary policy is state dependent: once the recession has left substantial scars, monetary policy cannot speed up a slow recovery, or escape from an unemployment trap.

Endogenous Growth, Skill Obsolescence, and Output Hysteresis in a New Keynesian Model with Unemployment

“…Acharya et al. (2018) analyze monetary policy in a model with the zero‐lower bound constraint and hysteresis effects whereby skill loss generates multiplicity of steady‐state unemployment. Waletin and Westermark (2018) quantify the importance of human capital dynamics and job mismatch in slowing down the recovery from the Great Recession.…”

“…Craighead (2019) models unemployment hysteresis as deterioration in labor market matching efficiency from higher average duration of unemployment. By contrast, our framework focuses on output hysteresis.8 Esteban-Pretel and Faraglia (2010) andAcharya et al (2018) assume that new hires are equally productive as existing workers once a fixed training cost to 'upgrade' the human capital of new hires has been paid.…”

“…Esteban-Pretel and Faraglia (2010) analyze skill loss during unemployment in a New Keynesian model and show that the skill loss mechanism helps to explain the magnitude of the response of unemployment to monetary shocks. Acharya et al (2018) analyze monetary policy in a model with the zero-lower bound constraint and hysteresis effects whereby skill loss generates multiplicity of steady-state unemployment. 2 Waletin and Westermark (2018) quantify the importance of human capital dynamics and job mismatch in slowing down the recovery from the Great Recession.…”

A prolonged period of low interest rates in Europe: Unintended consequences

“…Some studies argue that monetary policy was not accommodative enough after the GFC, and that this had significant long-run costs in terms of low inflation, slow recovery, and heightened unemployment. For instance, Acharya et al (2018) show that, given the magnitude of the shock during the GFC, monetary policy in the United States was accommodative enough to avert permanent stagnation, but not enough to prevent a slow recovery. Similarly, Cúrdia et al (2015) show that while monetary policy was accommodative relative to the Taylor rule, it was not accommodative enough to prevent the interest rate gap from increasing and output from falling below potential.…”

“…For instance, Acharya et al. (2018) show that, given the magnitude of the shock during the GFC, monetary policy in the United States was accommodative enough to avert permanent stagnation, but not enough to prevent a slow recovery. Similarly, Cúrdia et al.…”