An explanation of unemployment persistence: The role of monetary policy shock and the household as a transmission channel
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This paper studies the role of Federal Reserve's monetary policy shocks in widening distortions in the US labor market. Such distortions appear in the data as persistent hump-shaped responses in unemployment and output levels. The standard New Keynesian model has failed to generate such persistence, even with the inclusion of frictions like staggered wage contracts and habit formation. Adding a simple labor market matching model with heterogenous response by the households and the firms overcomes these shortcomings. We show that adverse monetary policy shocks to curb inflationary pressures increase the reservation opportunity cost of not working, by increasing the debt servicing burden of households. These same shocks reduce product demand, causing the reservation productivity a firm is willing to accept from new hires to increase. Thus labor supply increases as a result of adverse monetary shocks while labor demand falls or remains unchanged, thereby widening the cyclical variations between job destruction and job creation. This gap between desired and actual employment and output levels is suggested as a cause of observed unemployment persistence.