econintersect.com
       
  

FREE NEWSLETTER: Econintersect sends a nightly newsletter highlighting news events of the day, and providing a summary of new articles posted on the website. Econintersect will not sell or pass your email address to others per our privacy policy. You can cancel this subscription at any time by selecting the unsubscribing link in the footer of each email.



posted on 20 November 2016

Escaping Unemployment Traps

from Liberty Street Economics

-- this post authored by Sushant Acharya, Julien Bengui, Keshav Dogra, and Shu Lin Wee

Economic activity has remained subdued following the Great Recession. One interpretation of the listless recovery is that recessions inflict permanent damage on an economy’s productive capacity. For example, extended periods of high unemployment can lead to skill losses among workers, reducing human capital and lowering future output.

This notion that temporary recessions have long-lasting consequences is often termed hysteresis. Another explanation for sluggish growth is the influential secular stagnation hypothesis, which attributes slow growth to long-term changes in the economy’s underlying structure. While these explanations are observationally similar, they have very different policy implications. In particular, if structural factors are responsible for slow growth, then there might be little monetary policy can do to reverse this trend. If instead hysteresis is to blame, then monetary policy may be able to reverse slowdowns in potential output, or even prevent them from occurring in the first place.

We created a theoretical model to investigate this issue. A crucial assumption underlying the model is that workers lose human capital while unemployed and that it is costly for firms to retrain unemployed workers. (There is a large empirical literature documenting the scarring effects of unemployment; see, for example, these papers by Wee and Song and Wachter. The potential for skill loss generates multiple possible long-run outcomes, or steady states. One favorable steady state corresponds to a high-pressure economy with high job-finding rates, low unemployment, and new hires requiring little training. However, the economy can also be trapped in an undesirable steady state, corresponding to a low-pressure economy with low job-finding rates, high unemployment, and a significant loss of human capital. Crucially, in the absence of nominal rigidities, and in the absence of external shocks, both steady states will persist, with a low-pressure economy never able to transition to a high-pressure economy.

To study the effect of monetary policy under such circumstances, we assume that that there is some form of nominal rigidity in the economy - namely, that nominal wages are sticky (as documented empirically in a 2016 paper by Fallick, Lettau, and Wascher, among many others). The assumption that nominal wages adjust slowly allows monetary policy to influence economic activity. We then proceed to evaluate two monetary policy regimes. The first is a price level target (PLT) that keeps prices at a level consistent with a high-pressure economy. The second is a “neutral" monetary policy, which seeks to maintain the level of output that would exist if wages were flexible. The key difference is that neutral monetary policy allows for higher prices than PLT, and so provides more stimulus after a deep recession.

Using the model, we find that these two policy rules engineer a swift recovery to the high-pressure steady state in response to small temporary shocks. This isn’t surprising since a substantial literature in monetary economics argues that policies promoting price stability have desirable outcomes. However, we find that these rules may fail to restore the economy to full employment when faced with large shocks.

Under price level targeting, a large negative shock causes prices to fall, increasing real wages and reducing hiring. The fall in hiring, in turn, lengthens the average duration of unemployment and reduces human capital. Even after the shock dissipates, it is costly for firms to retrain workers who lost human capital. Temporarily lower real wages (that is, higher prices) could compensate firms for these training costs and stimulate hiring. A price level target, however, does not permit enough of a rise in prices, causing a permanent decline in hiring and employment. It is worth noting that this result runs counter to a large literature that finds that PLT performs very well (relative to inflation targeting) in many circumstances (see also this 2013 blog post). In particular, in a liquidity trap, PLT is more expansionary than inflation targeting, because it commits to reverse the fall in inflation that occurs during the downturn. PLT does all of these things in our model - but in the presence of hysteresis, even PLT is not expansionary enough.

Neutral monetary policy fares only slightly better. Recall that this policy seeks to replicate outcomes that would arise in an economy with flexible wages. After the initial shock, this policy rule recognizes that potential output is lower, and raises prices accordingly. However, this monetary policy generates at best a slow recovery, and at worst, permanent stagnation. While it permits a larger rise in prices than PLT, the increase is still not enough to generate a speedy recovery.

In an economy vulnerable to hysteresis, monetary policy rules that fare well in normal times can lead to pathological outcomes when faced with large shocks. Alternative rules can do better. Forward guidance - specifically, a commitment to deliberately overshoot the inflation target, even once the economy has returned to full employment - can mitigate deflationary pressures during the recession and moderate employment losses. Thus, a monetary policy stance that is more accommodative than neutral monetary policy may be able to avert unemployment traps altogether.

Of course, the best way to escape unemployment traps is to avoid entering them in the first place. However, this may not be very useful advice for economies already dealing with stagnation. Is there anything that can be done in these cases? In other words, is the damage from an unemployment trap reversible? It depends. A commitment to keep prices elevated for an extended period of time may boost hiring until the economy returns to full employment. Just as recessions damage potential output, booms can repair it. However, this only works to the extent that monetary policy can create a boom, and not just avert a recession. Another possibility is that after some point, additional monetary stimulus only leads to higher prices without increasing economic activity. If this is in fact the case, then monetary policy cannot engineer hiring booms and is powerless to help the economy escape an unemployment trap. Other measures, such as fiscal policy, would then be required. This suggests that it becomes all the more important to prevent the economy from entering such a trap in the first place, and lends support to the view that the risks associated with monetary easing are asymmetric. That is, excessive easing can be reversed, but excessive tightening may cause irreversible damage to the economy’s potential output.

In the research described in this blog, we focus on the effect of recessions on human capital. Recessions may affect potential output through other channels as well, such as lower capital accumulation, lower labor force participation, slow productivity growth, and so forth. Our research would suggest that to the extent that these mechanisms are operative, a monetary policy that seeks to track measured natural rates - of unemployment, interest rates, and so forth - might be insufficiently accommodative to engineer a full and quick recovery after a large recession. Such policies fall short because in a world with hysteresis, “natural" rates are endogenous. Policy should set these rates, not track them.

Whether or not hysteresis is severe enough to support such a conclusion is ultimately an empirical question. It is particularly important to ascertain whether secular stagnation or hysteresis is responsible for sluggish growth, because while they are observationally similar, the two warrant very different policy prescriptions.

Disclaimer

The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

Source

http://libertystreeteconomics.newyorkfed.org/2016/11/escaping-unemployment-traps.html


About the Authors

Acharya_sushantSushant Acharya is an economist in the Federal Reserve Bank of New York’s Research and Statistics Group.

Julien Bengui is an assistant professor of economics at Université de Montréal.

Keshav_dograKeshav Dogra is an economist in the Bank’s Research and Statistics Group.

Shu Lin Wee is an assistant professor of economics at the Carnegie Mellon Tepper School of Business.

>>>>> Scroll down to view and make comments <<<<<<

Click here for Historical News Post Listing










Make a Comment

Econintersect wants your comments, data and opinion on the articles posted.  As the internet is a "war zone" of trolls, hackers and spammers - Econintersect must balance its defences against ease of commenting.  We have joined with Livefyre to manage our comment streams.

To comment, using Livefyre just click the "Sign In" button at the top-left corner of the comment box below. You can create a commenting account using your favorite social network such as Twitter, Facebook, Google+, LinkedIn or Open ID - or open a Livefyre account using your email address.



You can also comment using Facebook directly using he comment block below.





Econintersect Contributors


search_box

Print this page or create a PDF file of this page
Print Friendly and PDF


The growing use of ad blocking software is creating a shortfall in covering our fixed expenses. Please consider a donation to Econintersect to allow continuing output of quality and balanced financial and economic news and analysis.


Take a look at what is going on inside of Econintersect.com
Main Home
Analysis Blog
Big Mess in Italy
Are You Feeling the Economic Surge?
News Blog
Are All Collateralized Loan Obligations Equal?
A Third Of Homes Sold For The List Price Or More In August 2016
It Is Still Not Too Late To Find A Seasonal Job
Infographic Of The Day: Are You A Good Listener
Early Headlines: Italy Votes 'No', Renzi Resigns, Euro Plunges 2 Pct, Asia Stocks Down, Trump Foreign Policy By Tweet, Dakota Pipeline Stopped, India Serv. PMI Contracts And More
Most Read Articles Last Week Ending 03 December
The World's Most Creative Cities
The Countries Where People Aren't Interested In Politics
Fidel Castro And The Revolution That Almost Wasn't
America Trumps Allies In Defense Spending
What We Read Today 04 December 2016
How Much Money It Costs To Make Money
Multiple Jobs Needed To Make Ends Meet
Investing Blog
Market Sector Analysis: 04 December 2016
Trumponomics: The New Hope
Opinion Blog
The Labor Market Working Nine To Five
Why Did Trump Win? A Different Perspective, Part 3
Precious Metals Blog
Silver Prices Rebounded Today: Where They Are Headed
Live Markets
02Dec2016 Market Close: WTI Crude Climbed Back Up To Previous 51 Handle, US Dollar Index Trading At The100 Level, Oil Rig Count At 10-Month High
Amazon Books & More






.... and keep up with economic news using our dynamic economic newspapers with the largest international coverage on the internet
Asia / Pacific
Europe
Middle East / Africa
Americas
USA Government



Crowdfunding ....






























 navigate econintersect.com

Blogs

Analysis Blog
News Blog
Investing Blog
Opinion Blog
Precious Metals Blog
Markets Blog
Video of the Day
Weather

Newspapers

Asia / Pacific
Europe
Middle East / Africa
Americas
USA Government
     

RSS Feeds / Social Media

Combined Econintersect Feed
Google+
Facebook
Twitter
Digg

Free Newsletter

Marketplace - Books & More

Economic Forecast

Content Contribution

Contact

About

  Top Economics Site

Investing.com Contributor TalkMarkets Contributor Finance Blogs Free PageRank Checker Active Search Results Google+

This Web Page by Steven Hansen ---- Copyright 2010 - 2016 Econintersect LLC - all rights reserved