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labor economics question

Economics
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why is the concept of inertia important when determining the effects of labor market frictions?

Mar 1st, 2015

What accounts for the significant real effects of monetary policy shocks? And what accounts for the persistent and hump shaped responses of output and inflation in response to such shocks? In recent years, monetary economists have increasingly employed dynamic stochastic general equilibrium (DSGE) models based on monopolistic competition and nominal rigidities to study the impacts of monetary policy. The work of Yun (1996), Rotenberg and Woodford (1997), Good friend and King (1997), McCallum and Nelson (1999), and others helped to popularize this “new Keynesian” approach. However, the first generation of these models proved unable to generate the persistent output and inflation responses to shocks that are displayed in the data. This was true of the response of inflation to monetary policy shocks (Nelson 1998), as well as the response of real output. In addition, the degree of price stickiness obtained in estimated new Keynesian Phillips curves is much higher than suggested by micro data on price adjustment. In response to these shortcomings, numerous extensions designed to generate more persistence have been explored. These extensions include structural inflation inertia, habit persistence, variable capital utilization, and sticky wages. Less attention has been paid to the role of monetary policy itself in producing the persistence responses of output and inflation seen in the data. For example, forward-looking models of consumption imply that both current and expected future interest rates matter for current spending decisions, implying that the real output effects of transitory interest rate shocks are likely to be much smaller than the effects of shocks that generate persistent interest rate movements.

The model economy.

The model consists of households, firms, and a monetary authority. Goods are produced in a competitive wholesale sector, where production requires that a firm and a worker be matched. Wholesale firms sell their output to retail firms, of which there are a continuum of mass one. Retail firms sell differentiated goods to households, and the retail sector is characterized by monopolistic competition and price stickiness. The labor market aspects of the model are similar to that employed in Walsh (2003), but several modifications to policy, price setting, household behavior are introduced. Replace the assumption of an exogenous money growth rate rule with an interest rate rule. Second, to allow for multiple sources of persistence, I adopt the inflation adjustment specification of Christiano, Eichenbaum, and Evans (2001), which introduces structural inflation inertia, and I incorporate habit persistence in the preferences of the representative household. These last two modifications have been shown to improve the performance of standard new Keynesian models. The resulting model is convenient for assessing the relative roles of nominal price stickiness, habit persistence, labor market search, and policy inertia on the dynamics of output and inflation. The representative household purchases consumption goods, holds money and supplies one unit of labor inelastic. Thus, the focus is on the extensive employment margin and not, as is more typical, on the intensive hour’s margin. Since some workers will be matched, while others will not be, distributional issues arise. To avoid these issues, I assume households pool consumption.6 Households are also the owners of all firms in the economy. In models with sticky prices, output responds to demand shifts; if consumption is purely forward looking and there is no investment, consumption and output jump immediately in response to interest rate shocks. To match the hump shaped response of output seen in the data, habit persistence has become a standard component of new Keynesian models.

Households:

The representative household purchases consumption goods, holds money, and supplies one unit of labor inelastic. Thus, the focus is on the extensive employment margin and not, as is more typical, on the intensive hour’s margin.5 Since some workers will be matched, while others will not be, distributional issues arise. To avoid these issues, I assume households pool consumption. Households are also the owners of all firms in the economy. In models with sticky prices, output responds to demand shifts; if consumption is purely forward looking and there is no investment, consumption and output jump immediately in response to interest rate shocks. To match the hump shaped response of output seen in the data, habit persistence has become a standard component of new Keynesian models (Fuhrer 2000, Christiano, Eichenbaum, and Evans 2001).

Calibration and summary statistics.

The properties of the model are investigated by studying a linearized version of the Equilibrium conditions, expressed in terms of percentage deviations around the steady state. Five sets of parameters characterize the model — those describing 1) household preferences, 2) the aggregate matching function and the labor market, 3) the degree of price rigidity at the retail level, 4) the behavior of the nominal interest rate, and 5) the stochastic distribution of the exogenous shocks. Parameter values are chosen to be largely consistent with those standard in nonmonetary models and with estimated new Keynesian models This paper has incorporated nominal price stickiness, habit persistence, and policy inertia into a model of labor market search to study the dynamic impact of nominal interest rate shocks. The model produces real output and inflation responses to nominal interest rate shocks that display the hump shaped pattern typically seen in estimated VARs. Labor market rigidities introduced by the process of matching job seekers with job vacancies amplify the real impact and reduce the inflation impact of a nominal interest rate shock. As a consequence, much less nominal rigidity is necessary in the labor market search model than in the corresponding new Keynesian model. 


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