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Supply Shocks, Employment Gap, and Monetary Policy

March 7, 2025
Takushi Kurozumi*1
Willem Van Zandweghe*2

Abstract

How should monetary policy respond to supply shocks in terms of inflation and employment stabilization? We introduce labor force entry and exit in an otherwise standard model with staggered price- and wage-setting to include employment in the model. A welfare-maximizing policy features wage growth stabilization with variation in the employment gap and inflation. Under staggered price- and wage-setting, the real wage adjustments to shocks entail a welfare cost, and variation in the employment gap contributes to reducing the welfare cost. Therefore, leaning against the employment gap induces substantial welfare losses for supply shocks compared to the welfare-maximizing policy.

JEL classification
E24, E31, E52, J21

Keywords
Labor force entry and exit, Extensive margin of labor, Staggered price- and wage-setting, Wage growth stabilization

The authors are grateful to Hassan Afrouzi, Kosuke Aoki, Mark Bils, Gian Luca Clementi, Paolo Gelain, Baris Kaymak, Dirk Krueger, So Kubota, Jean-Paul L'Huillier, Pierlauro Lopez, André Luduvice, Kurt Lunsford, Junior Maih, Toshihiko Mukoyama, Juan Pablo Nicolini, Evi Pappa, Ricardo Reis, Juan Rubio-Ramírez, Aysegul Sahin, Cynthia Wu, and participants at the 2023 AEA meeting, 2023 SNDE symposium, Spring 2024 Midwest Macro Meeting, and seminars at the Bank of Japan, the Federal Reserve Bank of Cleveland, and Tohoku University for valuable comments and discussions. Martin DeLuca provided excellent research assistance. The views expressed in this paper are those of the authors and do not necessarily reflect those of the Bank of Japan, the Federal Reserve Bank of Cleveland, or the Federal Reserve System.

  1. *1Research and Statistics Department, Bank of Japan
    E-mail : takushi.kurozumi@boj.or.jp
  2. *2Research Department, Federal Reserve Bank of Cleveland
    E-mail : willem.vanzandweghe@clev.frb.org

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