Insider-Outsider Labor Markets, Hysteresis and Monetary Policy

• Authors: Jordi Galí.
• BSE Working Paper: 112128 | February 16
• Keywords: wage stickiness , New Keynesian model , unemployment fluctuations , Phillips curve , monetary policy tradeoffs
• JEL codes: E24, E31, E32
• wage stickiness
• New Keynesian model
• unemployment fluctuations
• Phillips curve
• monetary policy tradeoffs

I develop a version of the New Keynesian model with insider- outsider labor markets and hysteresis that can account for the high persistence of European unemployment. I study the implications of that environment for the design of monetary policy. The optimal policy calls for strong emphasis on (un)employment stabilization which a standard interest rate rule fails to deliver, with the gap between the two increasing in the degree of hysteresis. Two simple targeting rules are shown to approximate well the optimal policy. The properties of the model and effects of different policies are analyzed through the lens of the labor wedge and its components.