Layoff risk, the welfare cost of business cycles, and monetary policy

The single strongest predictor of changes in the Fed Funds rate in the period 1982--2007 was the level of the layoff rate (initial unemployment claims divided by total employment). This fact is puzzling from the perspective of standard monetary models because they typically imply that the welfare gains of stabilizing employment fluctuations are small. We argue that these welfare costs are small because standard models do not capture the fact that when people lose their jobs, they tend to experience large, permanent, and largely uninsurable income losses. We augment a standard New Keynesian model with a labor market featuring endogenous countercyclical layoffs by firms that are associated with permanent reductions in human capital. In our benchmark calibration, welfare may be increased by 4 percent of lifetime consumption when the central bank's policy rule responds to the layoff rate. This provides a quantitative rationale for the Federal Reserve's dual mandate.