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Optimal Monetary Policy in the Presence of Human Capital Depreciation during Unemployment

  • Lien Laureys

    ()

    (Bank of England
    Centre for Macroeconomics (CFM))

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    When workers are exposed to human capital depreciation during periods of unemployment, hiring affects the unemployment pool’s composition in terms of skills, and hence the economy’s production potential. Introducing human capital depreciation during unemployment into an otherwise standard New Keynesian model with search frictions in the labour market leads to the finding that the flexibleprice allocation is no longer constrained-efficient even when the standard Hosios (1990) condition holds. This is because it generates a composition externality in job creation: firms ignore how their hiring decisions affect the extent to which the unemployed workers’ skills erode, and hence the output that can be produced by new matches. Consequently, it might be desirable from a social point of view for monetary policy to deviate from strict inflation targeting. Although optimal price inflation is no longer zero, strict inflation targeting is shown to stay close to the optimal policy.

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    File URL: http://www.centreformacroeconomics.ac.uk/Discussion-Papers/2014/CFMDP2014-15-Paper.pdf
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    Paper provided by Centre for Macroeconomics (CFM) in its series Discussion Papers with number 1415.

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    Length: 46 pages
    Date of creation: Jun 2014
    Date of revision:
    Handle: RePEc:cfm:wpaper:1415
    Contact details of provider: Web page: http://www.centreformacroeconomics.ac.uk/

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    1. Schmieder, Johannes F. & Wachter, Till von & Bender, Stefan, 2014. "The Causal Effect of Unemployment Duration on Wages: Evidence from Unemployment Insurance Extensions," IZA Discussion Papers 8700, Institute for the Study of Labor (IZA).
    2. Federico Ravenna & Carl E. Walsh, 2011. "Welfare-Based Optimal Monetary Policy with Unemployment and Sticky Prices: A Linear-Quadratic Framework," American Economic Journal: Macroeconomics, American Economic Association, vol. 3(2), pages 130-62, April.
    3. Ravenna, Federico & Walsh, Carl E., 2012. "Monetary policy and labor market frictions: A tax interpretation," Journal of Monetary Economics, Elsevier, vol. 59(2), pages 180-195.
    4. Julen Esteban-Pretel & Elisa Faraglia, 2005. "Monetary Shocks in a Model with Loss of Skills," CIRJE F-Series CIRJE-F-380, CIRJE, Faculty of Economics, University of Tokyo.
    5. Addison, John T & Portugal, Pedro, 1989. "Job Displacement, Relative Wage Changes, and Duration of Unemployment," Journal of Labor Economics, University of Chicago Press, vol. 7(3), pages 281-302, July.
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