Labor market participation, unemployment and monetary policy
A study of how the introduction of the labor market participation margin in an otherwise standard DSGE model with matching frictions and nominal rigidities affects business cycle dynamics and monetary policy
In the present paper the authors examine how the introduction of endogenous participation in an otherwise standard DSGE model with matching frictions and nominal rigidities affects business cycle dynamics and monetary policy. The authors highlight the fact that the given model is able to account remarkably well for US business cycle evidence.
Throughout the paper, the authors study the effects of strict inflation targeting predicted by the model. In particular, the main finding of the paper is that the presence of the participation margin overturns the conventional conclusions one obtains with a model featuring exogenous participation.
For instance, it is well known that switching from a flexible to a strict inflation targeting regime magnifies the volatility of the unemployment rate, conditionally on technology shocks. In contrast, within the framework of the present model that includes the labor market participation margin, unemployment volatility falls when the central bank switches to a strict inflation targeting policy. This is the opposite of what a model abstracting from endogenous fluctuations of the labor force would predict.
The authors also illustrate the quantitative importance of households’ search costs in two respects: in shaping the role of matching frictions in the participation decision and in affecting the strength of the policy transmission channel acting through the labor force.
To sum up, the contribution of the paper is threefold:
the model in this paper provides a good fit for employment and unemployment volatility, as well as participation volatility and its correlation with output for US data
the authors find that in such a model, and contrary to a model with exogenous participation, a monetary authority that becomes more aggressive in fighting inflation decreases the volatility of employment and unemployment
the paper highlights the role of search costs in shaping those results
Finally, the authors conclude that their finding has interesting implications. Macro policies that address the issue of unemployment fluctuations cannot abstract from the fact that incentives to substitute involuntary unemployment with voluntary non-employment are not invariant to policy.
The intuition is straightforward: the incentives driving participation in the labor force respond to frictions. In turn, monetary policy affects the relevance of frictions over the business cycle. Therefore, the monetary policy regime affects households’ willingness to move from unemployment to voluntary non-employment and the other way around.