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Inflation and Unemployment in the Long Run

  • Aleksander Berentsen

    ()

    (Department of Economics, University of Basel)

  • Guido Menzio

    ()

    (Department of Economics, University of Pennsylvania)

  • Randall Wright

    ()

    (Department of Economics, University of Pennsylvania)

We study the long-run relation between money, measured by inflation or interest rates, and unemployment. We first discuss data, documenting a strong positive relation between the variables at low frequencies. We then develop a framework where both money and unemployment are modeled using explicit micro-foundations, integrating and extending recent work in macro and monetary economics, and providing a unified theory to analyze labor and goods markets. We calibrate the model, to ask how monetary factors account quantitatively for low-frequency labor market behavior. The answer depends on two key parameters: the elasticity of money demand, which translates monetary policy to real balances and profits; and the value of leisure, which affects the transmission from profits to entry and employment. For conservative parameterizations, money accounts for some but not that much of trend unemployment — by one measure, about 1/5 of the increase during the stagflation episode of the 70s can be explained by monetary policy alone. For less conservative but still reasonable parameters, money accounts for almost all low-frequency movement in unemployment over the last half century.

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Paper provided by Penn Institute for Economic Research, Department of Economics, University of Pennsylvania in its series PIER Working Paper Archive with number 08-012.

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Length: 74 pages
Date of creation: 18 Mar 2008
Date of revision:
Handle: RePEc:pen:papers:08-012
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