We introduce duration dependent skill decay among the unemployed into a New-Keynesian model with hiring frictions developed by Blanchard/Gali (2008). If the central bank responds only to (current, lagged or expected future) inflation and quar¬terly skill decay is above a threshold level, determinacy requires a coefficient on infla¬tion smaller than one. The threshold level is plausible with little steady-state hiring and firing ("Continental European Calibration") but implausibly high in the oppo¬site case ("American calibration"). Neither interest rate smoothing nor responding to the output gap helps to restore determinacy if skill decay exceeds the threshold level. However, a modest response to unemployment guarantees determinacy. Moreover, under indeterminacy, both an adverse sunspot shock and an adverse technology shock increase unemployment extremely persistently.
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Paper provided by Centre for Dynamic Macroeconomic Analysis in its series CDMA Working Paper Series with number
0909.