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

Author(s): Stephanie Schmitt-Groh� and Mart�n Uribe

Publication Date: December 2012

Keyword(s): Confidence shock, Jobless Recoveries, Liquidity Traps, Taylor Rule and Wage rigidity

Programme Area(s): International Macroeconomics

Abstract: 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.

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Bibliographic Reference

Schmitt-Groh�, S and Uribe, M. 2012. 'The Making Of A Great Contraction With A Liquidity Trap and A Jobless Recovery'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=9237