Slow Recoveries and Unemployment Traps: Monetary Policy in a Time of Hysteresis∗

Abstract

We analyse monetary policy in a model where temporary shocks can permanently scar the economy's productive capacity. Workers lose skill while unemployed and are costly to retrain, generating multiple steady-state unemployment rates. Following a large shock, unless monetary policy acts aggressively and quickly enough to prevent a significant rise in unemployment, hiring falls to a point where the economy recovers slowly at best - at worst, it falls into a permanent unemployment trap. Monetary policy can only avoid these outcomes if it commits in a timely manner to more accommodative policy in the future. Timely commitment is essential as the effectiveness of monetary policy is state dependent..