Layoff Risk, the Welfare Cost of Business Cycles, and Monetary Policy
65 Pages Posted: 14 Sep 2015 Last revised: 12 Apr 2019
Date Written: April 4, 2019
The strongest predictor of changes in the Fed Funds rate in the period 1982–2008 was the layoff rate. That fact is puzzling from the perspective of representative-agent models of the economy, which imply that the welfare gains of stabilizing employment fluctuations are small. This paper augments a standard New Keynesian model with a labor market featuring countercyclical layoffs that lead to large,uninsurable, and permanent idiosyncratic wage declines. In our benchmark calibration, welfare may be increased by 1 percent of lifetime consumption or more when the central bank’s policy rule responds to the layoff rate instead of purely targeting inflation.
Keywords: Layoff risk, monetary policy, heterogeneous agents, business cycles
JEL Classification: E12, E21, E24, E43, E52, E58
Suggested Citation: Suggested Citation