The Making Of A Great Contraction. With A Liquidity Trap And A Jobless Recovery. Columbia University

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1 The Making Of A Great Contraction With A Liquidity Trap And A Jobless Recovery Stephanie Schmitt-Grohé Martín Uribe Columbia University November 5, 2013

2 A jobless recovery is a situation in which: Output growth recovers, but employment does not. Bernanke (2009). 2

3 A liquidity trap is a situation in which: The nominal interest rate is zero; and Expected inflation is below target. 3

4 Two historical examples of great contractions with a liquidity trap and a jobless recovery: Great Contraction of 2008 in the United States. Double Dip Recession of Japan in the 1990s. 4

5 U.S. Real Per Capita GDP Growth: percent per year Source: Bureau of Economic Activity. 5

6 U.S. Civilian Employment-Population Ratio: Q percent Source: Bureau of Labor Statistics. 6

7 The U.S. recovery from the Great Contraction of 2008 was jobless. 7

8 6 U.S. Federal Funds Rate: percent Source: Federal Reserve Board. 8

9 U.S. 10-Year Expected Inflation: 2005Q1-2012Q percent Source: Federal Reserve Bank of Cleveland. 9

10 The Great Contraction of 2008 pushed the U.S. economy into a liquidity trap. 10

11 Japan The Double-Dip Recession

12 Real Per Capita GDP Growth 4qtr, Japan, Real Per Capita GDP Growth Percent Per Year Year 12

13 63 Japan, Employment to Population Ratio 62 Percent Year 13

14 5 Japan, Unemployment Rate 4.5 Percent Year 14

15 The recovery from the recessions of the 1990s in Japan was jobless. 15

16 Japan, Call Rate 8 Percent Per Year Year 16

17 Year over Year Growth of GDP Deflator, Japan, Inflation Percent Per Year Year 17

18 In the 1990s Japan fell into a liquidity trap. 18

19 This paper develops a theoretical model that predicts that a confidence shock can lead the economy into a liquidity trap with a jobless recovery. 19

20 Four Key Elements of the Argument: 1. Downward Nominal Wage Rigidity. 2. Monetary Policy follows a Taylor Rule. 3. The Zero Lower Bound On Nominal Interest Rates. 4. A Downward Revision in Inflation Expectations. 20

21 Related Papers on Liquidity Traps: Krugman, 1998; Eggertson and Woodford, 2003; Benhabib, Schmitt-Grohé, and Uribe, 2001; Related Papers on Jobless Recoveries: Shimer (2012); Calvo, Coricelli, and Ottonello (2012); Related Papers on Interpreting the Great Recession as a Self-fulfilling Crisis: Aruoba and Schorfheide, 2012; Mertens and Ravn, 2012; 21

22 Element 1: Downward Nominal Wage Rigidity. W t γ(u t ) W t 1, where W t nominal wage rate u t, unemployment rate Assumption: γ (u) < 0 22

23 Empirical Evidence on Downward Nominal Wage Rigidity 23

24 Probability of Decline, Increase, or No Change in Nominal Wages Between Interviews U.S. data, SIPP panel , within-job changes Interviews One Year apart Males Females Decline 5.1% 4.3% Constant 53.7% 49.2% Increase 41.2% 46.5% Source: Gottschalk (2005) Note. Male and female hourly workers not in school, 18 to 55 at some point during the panel. All nominal-wage changes are within-job wage changes, defined as changes while working for the same employer. 24

25 Quarterly, Source: Barattieri, Basu, and Gottschalk (2010) 25

26 Distribution of Nominal Wage Changes, 2011, USA Source: Daly et al. (2012). Workers in the same industry and occupation. 26

27 Distribution of Nominal Wage Changes, 2011, USA Source: Elsby et al. (2013). Hourly workers in the same employer. 27

28 Elements 2 and 3 Monetary Policy Follows a Taylor Rule. The Zero Lower Bound on Nominal Interest Rates. R t = max { 1,R + α π ( πt π ) + α y ln ( )} Yt Yt α π > 1, α y > 0 28

29 Households Preferences: E 0 t=0 e ξ t β t U(C t ) Budget constraint: P t C t + B t + T t = W t h t + R t 1 B t 1 + Φ t Inelastic Labor Supply: h t h 29

30 Firms Production function: Y t = X t F(h t ); with X t /X t 1 = µ > 1 Labor demand: P t X t F (h t ) = W t 30

31 The Labor Market h t h W t γ(u t )W t 1 ( h h t ) ( W t γ(u t )W t 1 ) = 0 31

32 Equilibrium: Let w t W t e ξ t U (c t ) = βr t E t P t X t and c t C t /X t eξ t+1u (c t+1 ) π t+1 R t = max { 1, π β + α π ( πt π ) + α y ln ( F(ht ) F( h) )} c t = F(h t ) w t = F (h t ) h t h and w t γ(u t) π t µ w t 1; ( h h t ) ( w t γ(u t) π t µ w t 1 where u t h h t h ) = 0 32

33 A Key Inflation Threshold π γ(0) µ π t < π involuntary unemployment. 33

34 Steady State Equilibria: c t = c, h t = h, w t = w, π t = π, R t = R { R = π β R = max 1,R ( + α π π π ) + α y ln ( F(h) F( h) )} 34

35 Two Steady States π t+1 π βr t (π t ) β line β π π t 35

36 Multiple Steady States Proposition 1 (Existence of a Full-Employment Steady State) There exists a unique full-employment steady state (u = 0). Moreover, at the full-employment steady state the inflation rate equals the inflation target π. Proposition 2 (Existence of an Unemployment Steady State) There exists a unique unemployment steady state (u = ū > 0). Moreover, at the unemployment steady state the economy is in a liquidity trap (R = 1 and π = β < π ). 36

37 Element 4: A Downward Revision in Inflation Expectations (or confidence shock) π 0 < π 37

38 Proposition 3 (Liquidity Trap) Suppose that ξ t = 0 and deterministic for t 0. Further, assume that π 0 < π. Then, in any perfect foresight equilibrium, π t+1 < π t < π if π t γ(0) µ < γ(0) µ < π if π t < γ(0) µ, for all t 0. Furthermore, there exists a finite integer T 0 such that π T < γ(0) µ. Proposition 4 (Chronic Involuntary Unemployment) Suppose that ξ t = 0 and deterministic for t 0. Further, assume that π 0 < π. Then, in any perfect foresight equilibrium u t > 0 for all t T, where T 0 is the finite integer defined in proposition 3. 38

39 F(h) = h α ; with α = 0.75 Calibrated Example: u(c) = c 1 σ /(1 σ); with σ = 2 X t = /4 X t 1 ; β = /4 ; real rate of 4 percent π = /4 ; inflation target of 2 percent α π = 1.5 α y = γ(u t ) = γ 1 (1 u t ) γ 2; γ 1 = /4 ; γ 2 =

40 Calibration of the Degree of Downward Wage Rigidity, γ(u) = γ 1 (1 u) γ 2 Set γ 1 = /4 At the full-employment steady state, nominal wages must grow at a rate of 2% per year or higher. Weak restriction: due to productivity growth, lower bound on nominal wages does not bind in the intended steady state. Set γ 2 so that if unemployment is 5 percent above the natural rate, then wages can fall frictionlessly by up to 2 percent per year. This is a conservative criterion: Between 2008 and 2010, US unemployment increased from 5 to 10 percent, but nominal hourly wages did not fall. They actually grew by 3 percent per year. 40

41 Dynamics Under Lack of Confidence Shock Interest Rate Inflation 6 2 % annual t % annual t 1.8 Output Growth Rate 100 Employment Rate % annual t % t 41

42 A Lack of Confidence Shocks Leads to A Great Contraction A Liquidity Trap A Jobless Recovery 42

43 6 5 4 The U.S. Great Contraction of 2008 Federal Funds Rate 10 Year Expected Inflation percent 3 percent Real Per Capita GDP Growth 64 Civilian Employment Population Ratio percent percent

44 The Japanese Slump of the 1990s Call Rate 3 Inflation Percent Per Year Percent Per Year Year Year 6 Real Per Capita GDP Growth 63 Employment to Population Ratio Percent Per Year Percent Year Year 44

45 Alternative Hypothesis: What if inflationary expectations are well anchored (i.e., loss of confidence shocks are ruled out by assumption)? Specifically, consider the response to a decline in the natural rate of interest (following Eggertson and Woodford, 2003) Natural Rate of Interest = β 1 e ξ t ξ t+1 Exercise: Assume that the natural rate falls from its steadystate value of 4 percent per year to -2 percent per year for 10 quarters and then returns to 4 percent forever. 45

46 A Contraction With A Job-Creating Recovery: Response to a Persistent Decline In The Natural Rate 7 Interest Rate 5 Inflation % annual 4 3 % annual t t 5 Output Growth Rate 100 Employment Rate % annual t % t 46

47 A negative natural rate shock leads to unemployment and a liquidity trap However, the recovery features job creation. If inflationary expectations are well anchored, a persistent drop in the natural rate of interest cannot explain the observed jobless recovery. 47

48 Exiting The Slump with Truly Unconventional Monetary Policy Interest rate policy: R t = max { 1, π β + α π (π t π ) + α y ln ( )} F(ht ) F( h) if s t = 0 R if s t = 1. s t = { 1 if Rj = 1 for any 0 j < t 0 otherwise. 48

49 Exiting the Slump with Truly Unconventional Policy Interest Rate Inflation % annual 4 3 % annual t t 3 Output Growth Rate 100 Employment Rate % annual t % t 49

50 Response of Real Wages, W t /(P t X t ), and Inflation to a Nonfundamental Shock Under the Exit Strategy Real Wage 3 Inflation % per year Solid Line: Taylor Rule Dashed Line: Exit Strategy 50

51 Conclusions Great contraction of 2008 is characterized by a jobless recovery and a liquidity trap. When inflationary expectations are well anchored, standard model cannot explain jobless recoveries and a prolonged liquidity trap. U.S. could be suffering from a negative shock to inflation expectations. If so, conventional monetary policy, such as promising extended periods of low rates, is powerless. Instead, truly unconventional monetary policy, i.e., raising nominal rates, is needed to jolt the economy out of the slump. 51

52 Extras 52

53 Bernanke s Definition of a Jobless Recovery: Given this weakness in the labor market, a natural question is whether we might be in for a so-called jobless recovery, in which output is growing but employment fails to increase. Speech given by Chairman Ben S. Bernanke at the Economic Club of New York in New York on November 16,

54 Log of Real Per Capita GDP in U.S.: log of real GDP per capita Avg real GDP per capita grew by 1.1 percent between 2012Q4 and 2009Q2.(avg since 1990: 1.2 % 54

55 U.S. Unemployment Rate: percent Source: Bureau of Labor Statistics. 55

56 Source: Erceg and Levin (2013) 56

57 Source: Erceg and Levin (2013) 57

58 NYTimes, April 19, 2013 It was a relief just to find something, said Amie Crawford, 56, of Chicago. After four months looking for a new job as an interior designer, which she had been for 30 years before the recession, she accepted a position as a part-time cashier at a quick-service health-food cafe called Protein Bar. She keeps asking for more hours, but her manager s response is always the same. He tells me, I try to give you as many hours as I can, but everybody wants as many hours as they can, Ms. Crawford said. 58

59 10000 Involuntary Part Time Workers: 2002:Jan to 2013:March, LNS Thousands, 16 years and over Year Data Source: Bureau of Labor Statistics. 59

60 Real Wage Growth Held up Relatively Well During the 2008 Recession Source: Daly et al. April

61 Real Wage Growth relative to TFP Growth between 2008 and 2011 in the United States Fernald, FRBSF Productivity Data Base: Average Annual TFP Growth from 2008 to 2011 was 0.65 percent Daly et al. report that real wages grews by 1.1 percent per year on average between 2008 and Hence real wage growth exceeded TFP growth by 0.45 percent per year, for a total of 1.35 percent over the period

62 Assumption 1 The function γ(u t ) satisfies γ (u t ) < 0, and γ(0) > βµ, where β βµ σ. Assumption 2 The parameters R, π, and α π satisfy: R π β > 1, α π β > 1, π > γ(0) µ. 62

63 Dynamics Effects of a Fundamental Shock Under the Exit Strategy 7 Interest Rate 10 Inflation % annual 4 3 % annual t t 10 Output Growth Rate 100 Employment Rate % annual t % t Solid Line: Taylor Rule Dashed Line: Exit Strategy 63

64 Actual and Expected CPI Inflation, Japan, CPI Inflation, y/y 3 Actual CPI Inflation 2 5 year ahead Consensus Forecast Percent Per Year Ex post 5 year ahead CPI inflation Year Data Sources. CPI: Expected CPI Inflation from April and October survey of Consensus Forecast. 64

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