A model of euro area unemployment persistence and central bank stabilization policies

Empirical evidence suggests that euro area unemployment is highly persistent. Motivated by this, we develop a euro-area-calibrated monetary DSGE model that uniquely integrates financial frictions and employment hysteresis. Impulse response analysis shows that the model generates deep and persistent recessions that are not accompanied by significant deflation, questioning the effectiveness of standard inflation-focused monetary policy. This leads us to explore alternative “simple” (un)conventional monetary policy rules. We show that welfare-optimized policies that stabilize labor or financial markets outperform standard price inflation targeting. The welfare gains from adopting these alternative policies increase with hysteresis and the severity of the financial shock. Our findings underscore the importance of monitoring labor or financial market variables during financial crises and call for a re-evaluation of central bank policies in economies with persistent unemployment fluctuations.