Working Paper: CEPR ID: DP9237
Authors: Stephanie Schmitt-Grohé; Martín Uribe
Abstract: The great contraction of 2008 pushed the U.S. economy into a protracted liquidity trap (i.e., a long period with zero nominal interest rates and inflationary expectations below target). In addition, the recovery was jobless (i.e., output growth recovered but unemployment lingered). This paper presents a model that captures these three facts. The key elements of the model are downward nominal wage rigidity, a Taylor-type interest-rate feedback rule, the zero bound on nominal rates, and a confidence shock. Lack-of-confidence shocks play a central role in generating jobless recoveries, for fundamental shocks, such as disturbances to the natural rate, are shown to generate recessions featuring recoveries with job growth. The paper considers a monetary policy that can lift the economy out of the slump. Specifically, it shows that raising the nominal interest rate to its intended target for an extended period of time, rather than exacerbating the recession as conventional wisdom would have it, can boost inflationary expectations and thereby foster employment.
Keywords: confidence shock; jobless recoveries; liquidity traps; Taylor rule; wage rigidity
JEL Codes: E32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| negative confidence shock (D80) | decline in inflationary expectations (E31) |
| decline in inflationary expectations (E31) | real wages rise above full employment levels (J39) |
| real wages rise above full employment levels (J39) | chronic involuntary unemployment (J64) |
| negative confidence shock (D80) | chronic involuntary unemployment (J64) |
| Taylor rule fails to restore inflation to target levels (E31) | self-reinforcing cycle of low inflation and high unemployment (E31) |
| well-anchored inflationary expectations (E31) | recoveries characterized by output growth and job creation (O49) |
| raising nominal rates during a confidence shock (E43) | boost inflationary expectations and employment (E31) |