The Making Of A Great Contraction With A Liquidity Trap and A Jobless Recovery

By Stephanie Schmitt-Grohé and Martín Uribe

The great contraction of 2008 pushed the U.S. economy into a protracted liquidity trap (i.e., a long period with zero nominal interest rates and inflationary expectations below target). In addition, the recovery was jobless (i.e., output growth recovered but unemployment lingered). This paper presents a model that captures these three facts. The key elements of the model are downward nominal wage rigidity, a Taylor-type interest-rate feedback rule, the zero bound on nominal rates, and a confidence shock. Lack-of-confidence shocks play a central role in generating jobless recoveries, for fundamental shocks, such as disturbances to the natural rate, are shown to generate recessions featuring recoveries with job growth. The paper considers a monetary policy that can lift the economy out of the slump. Specifically, it shows that raising the nominal interest rate to its intended target for an extended period of time, rather than exacerbating the recession as conventional wisdom would have it, can boost inflationary expectations and thereby foster employment.

While this is a nice example of how a relatively simple model with the right ingredients can yields results that seems difficult to obtain with standard models, this paper is not convincing to me. First, it cannot explain previous jobless recoveries, as I think at least one ingredient is missing in every case. Second, I think we saw plenty of example of downward flexibility in nominal wages during the last recession, for example with furloughs. Third, as Reinhard and Rogoff have shown, recoveries from financial crises are very protracted and few of them have all the ingredients of this model (for example such low interest rates).

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