Monetary Persistence and the Labor Market: A New Perspective

It is common knowledge that the standard New Keynesian model is not able to generate a persistent response in output to temporary mone-tary shocks. We show that this shortcoming can be remedied in a simple and intuitively appealing way through the introduction of labor turnover costs (such as hiring and firing costs). Assuming that it is costly to hire and fire workers implies that the employment rate is slow to converge to its steady state value after a monetary shock. Under reasonable calibra-tions, the after-effects of a shock continue to exert an effect on the labor market even long after the shock is over. The sluggishness of the labor market translates to the product market and thus the output effects of the monetary shock become more persistent. Our model is able to gen-erate a hump-shaped response in output, if the monetary shock includes a moderate autoregressive component. This is another empirically well known feature, which the standard model is not able to replicate. ∗We would like to thank Marty Eichenbaum, Roland Winkler and the participants of the IfW staff seminar for very valuable suggestions. All remaining errors are our own. 1