The Making of a Great Contraction with a Liquidity Trap and a Jobless Recovery

39 Pages Posted: 20 Nov 2012

See all articles by Stephanie Schmitt-Grohé

Stephanie Schmitt-Grohé

Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Martín Uribe

Columbia University - Graduate School of Arts and Sciences - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: November 2012

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.

Suggested Citation

Schmitt-Grohe, Stephanie and Uribe, Martin, The Making of a Great Contraction with a Liquidity Trap and a Jobless Recovery (November 2012). NBER Working Paper No. w18544, Available at SSRN: https://ssrn.com/abstract=2178323

Stephanie Schmitt-Grohe (Contact Author)

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

National Bureau of Economic Research (NBER)

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Martin Uribe

Columbia University - Graduate School of Arts and Sciences - Department of Economics ( email )

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National Bureau of Economic Research (NBER)

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