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

Stephanie Schmitt-Groh´ e Mart ´ ın Uribe Columbia University November 5, 2013

A jobless recovery is a situation in which:

• Output growth recovers,
• but employment does not.

Bernanke (2009).

2

A liquidity trap is a situation in which:

• The nominal interest rate is zero; and
• Expected inflation is below target.

3

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

U.S. Real Per Capita GDP Growth: 2005-2012

2006 2008 2010 2012 −10 −5 5 percent per year

Source: Bureau of Economic Activity. 5

U.S. Civilian Employment-Population Ratio: 2005-2013Q1

2006 2008 2010 2012 58 59 60 61 62 63 64 percent

Source: Bureau of Labor Statistics. 6

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

7

U.S. Federal Funds Rate: 2005-2012

2006 2008 2010 2012 1 2 3 4 5 6 percent

Source: Federal Reserve Board. 8

U.S. 10-Year Expected Inflation: 2005Q1-2012Q4

2006 2008 2010 2012 1 1.5 2 2.5 3 percent

Source: Federal Reserve Bank of Cleveland. 9

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

10

Japan The Double-Dip Recession 1989 - 2001

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Real Per Capita GDP Growth 4qtr, Japan, 1989-2001

1990 1992 1994 1996 1998 2000 −2 2 4 6 Real Per Capita GDP Growth Year Percent Per Year

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Japan, 1989-2001

1990 1992 1994 1996 1998 2000 59 60 61 62 63 Employment−to−Population Ratio Year Percent

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Japan, 1989-2001

1990 1992 1994 1996 1998 2000 2 2.5 3 3.5 4 4.5 5 Unemployment Rate Year Percent

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

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Japan, 1989-2001 1990 1992 1994 1996 1998 2000 2 4 6 8 Call Rate Year Percent Per Year

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Year over Year Growth of GDP Deflator, Japan, 1989-2001

1990 1992 1994 1996 1998 2000 −2 −1 1 2 3 Inflation Year Percent Per Year

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

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

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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.

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Related Papers on Liquidity Traps: Krugman, 1998; Eggertson and Woodford, 2003; Benhabib, Schmitt-Groh´ e, 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;

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Element 1: Downward Nominal Wage Rigidity.

Wt ≥ γ(ut) Wt−1, where

• Wt nominal wage rate
• ut, unemployment rate

Assumption: γ′(u) < 0

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Empirical Evidence on Downward Nominal Wage Rigidity

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Probability of Decline, Increase, or No Change in Nominal Wages Between Interviews U.S. data, SIPP panel 1986-1993, 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

Quarterly, 1996-99. Source: Barattieri, Basu, and Gottschalk (2010)

25

Distribution of Nominal Wage Changes, 2011, USA

Source: Daly et al. (2012). Workers in the same industry and occupation.

26

Distribution of Nominal Wage Changes, 2011, USA

Source: Elsby et al. (2013). Hourly workers in the same employer.

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Elements 2 and 3

• Monetary Policy Follows a Taylor Rule.
• The Zero Lower Bound on Nominal Interest Rates.

Rt = max

• 1, R∗ + απ

πt − π∗ + αy ln

• Yt

Y ∗

t

• απ > 1,

αy > 0

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Households

Preferences: E0

∞

• t=0

eξtβtU(Ct) Budget constraint: PtCt + Bt + Tt = Wtht + Rt−1Bt−1 + Φt Inelastic Labor Supply: ht ≤ ¯ h

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Firms

Production function: Yt = XtF (ht); with Xt/Xt−1 = µ > 1 Labor demand: PtXtF ′(ht) = Wt

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The Labor Market

ht ≤ ¯ h Wt ≥ γ(ut)Wt−1 (¯ h − ht)

Wt − γ(ut)Wt−1 = 0

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Equilibrium: Let wt ≡

Wt PtXt and ct ≡ Ct/Xt

eξtU′(ct) = ˜ βRtEt

 eξt+1U′(ct+1)

πt+1

 

Rt = max

• 1, π∗

˜ β + απ

πt − π∗ + αy ln

• F (ht)

F (¯ h)

• ct = F (ht)

wt = F ′(ht) ht ≤ ¯ h and wt ≥ γ(ut) πtµ wt−1; where ut ≡ ¯ h − ht ¯ h (¯ h − ht)

• wt − γ(ut)

πtµ wt−1

• = 0

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A Key Inflation Threshold

¯ π ≡ γ(0) µ πt < ¯ π ⇒ involuntary unemployment.

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Steady State Equilibria: ct = c, ht = h, wt = w, πt = π, Rt = R R = π ˜ β R = max

• 1, R∗ + απ

π − π∗ + αy ln

• F (h)

F (¯ h)

• 34

Two Steady States

˜ β ˜ β π∗ π∗ ← ˜ βRt(πt) ← 450-line πt πt+1

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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 = ¯ u > 0). Moreover, at the unemployment steady state the economy is in a liquidity trap (R = 1 and π = ˜ β < π∗).

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Element 4: A Downward Revision in Inflation Ex- pectations (or confidence shock)

π0 < π∗

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Proposition 3 (Liquidity Trap) Suppose that ξt = 0 and de- terministic for t ≥ 0. Further, assume that π0 < π∗. Then, in any perfect foresight equilibrium, πt+1

  

< πt < π∗ if πt ≥ γ(0)

µ

< γ(0)

µ

< π∗ if πt < γ(0)

µ

, for all t ≥ 0. Furthermore, there exists a finite integer T ≥ 0 such that πT <

γ(0) µ .

Proposition 4 (Chronic Involuntary Unemployment) Suppose that ξt = 0 and deterministic for t ≥ 0. Further, assume that π0 < π∗. Then, in any perfect foresight equilibrium ut > 0 for all t ≥ T, where T ≥ 0 is the finite integer defined in proposition 3.

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Calibrated Example:

F (h) = hα; with α = 0.75 u(c) = c1−σ/(1 − σ); with σ = 2 Xt = 1.0151/4Xt−1; ˜ β = 1.04−1/4; real rate of 4 percent π∗ = 1.021/4; inflation target of 2 percent απ = 1.5 αy = 0.125 γ(ut) = γ1 · (1 − ut)γ2; γ1 = 1.021/4; γ2 = 0.19.

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Calibration of the Degree of Downward Wage Rigidity, γ(u) = γ1(1 − u)γ2

• Set γ1 = 1.021/4 ⇒ At the full-employment steady state, nom-

inal 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 γ2 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 un- employment increased from 5 to 10 percent, but nominal hourly wages did not fall. They actually grew by 3 percent per year.

40

Dynamics Under Lack of Confidence Shock

10 20 30 40 50 −4 −3 −2 −1 1 2 Inflation % annual t 10 20 30 40 50 94 95 96 97 98 99 100 Employment Rate % t 10 20 30 40 50 1 2 3 4 5 6 Interest Rate % annual t 10 20 30 40 50 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 Output Growth Rate % annual t

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⇒ A Lack of Confidence Shocks Leads to

• A Great Contraction
• A Liquidity Trap
• A Jobless Recovery

42

The U.S. Great Contraction of 2008

2006 2008 2010 2012 −10 −5 5 percent Real Per Capita GDP Growth 2006 2008 2010 2012 1 2 3 4 5 6 percent Federal Funds Rate 2006 2008 2010 2012 58 59 60 61 62 63 64 Civilian Employment−Population Ratio percent 2006 2008 2010 2012 1 1.5 2 2.5 3 10−Year Expected Inflation percent

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The Japanese Slump of the 1990s

1990 1992 1994 1996 1998 2000 2 4 6 8 Call Rate Year Percent Per Year 1990 1992 1994 1996 1998 2000 −2 −1 1 2 3 Inflation Year Percent Per Year 1990 1992 1994 1996 1998 2000 −2 2 4 6 Real Per Capita GDP Growth Year Percent Per Year 1990 1992 1994 1996 1998 2000 59 60 61 62 63 Employment−to−Population Ratio Year Percent

44

Alternative Hypothesis:

What if inflationary expectations are well anchored (i.e., loss

• f confidence shocks are ruled out by assumption)?

Specifically, consider the response to a decline in the natural rate

• f interest (following Eggertson and Woodford, 2003)

Natural Rate of Interest = ˜ β−1eξt−ξt+1 Exercise: Assume that the natural rate falls from its steady- state value of 4 percent per year to -2 percent per year for 10 quarters and then returns to 4 percent forever.

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A Contraction With A Job-Creating Recovery: Response to a Persistent Decline In The Natural Rate

5 10 15 20 −15 −10 −5 5 Inflation % annual t 5 10 15 20 93 94 95 96 97 98 99 100 Employment Rate % t 5 10 15 20 1 2 3 4 5 6 7 Interest Rate % annual t 5 10 15 20 −20 −15 −10 −5 5 Output Growth Rate % annual t

46

• 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

Exiting The Slump with Truly Unconventional Monetary Policy

Interest rate policy: Rt =

  

max

• 1, π∗

˜ β + απ (πt − π∗) + αy ln

• F(ht)

F(¯ h)

• if st = 0

R∗ if st = 1 . st =

• 1

if Rj = 1 for any 0 ≤ j < t

• therwise

.

48

Exiting the Slump with Truly Unconventional Policy

10 20 30 40 50 −4 −3 −2 −1 1 2 3 Inflation % annual t 10 20 30 40 50 94 95 96 97 98 99 100 Employment Rate % t 10 20 30 40 50 1 2 3 4 5 6 7 Interest Rate % annual t 10 20 30 40 50 0.5 1 1.5 2 2.5 3 Output Growth Rate % annual t

49

Response of Real Wages, Wt/(PtXt), and Inflation to a Nonfundamental Shock Under the Exit Strategy

10 20 30 40 50 0.75 0.752 0.754 0.756 0.758 0.76 0.762 0.764 Real Wage 10 20 30 40 50 −4 −3 −2 −1 1 2 3 Inflation % per year

Solid Line: Taylor Rule Dashed Line: Exit Strategy

50

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
• f 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

Extras

52

Bernanke’s Definition of a Jobless Recovery: “Given this weakness in the labor market, a natural ques- tion is whether we might be in for a so-called jobless re- covery, 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, 2009.

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Log of Real Per Capita GDP in U.S.: 1948-2012

1950 1960 1970 1980 1990 2000 2010 −4 −3.8 −3.6 −3.4 −3.2 −3 −2.8 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

U.S. Unemployment Rate: 2005-2012

2006 2008 2010 2012 4 5 6 7 8 9 10 11 percent

Source: Bureau of Labor Statistics. 55

Source: Erceg and Levin (2013) 56

Source: Erceg and Levin (2013) 57

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

2002 2004 2006 2008 2010 2012 2014 3000 4000 5000 6000 7000 8000 9000 10000 Involuntary Part−Time Workers: 2002:Jan to 2013:March, LNS12032197 Thousands, 16 years and over Year

Data Source: Bureau of Labor Statistics. 59

Real Wage Growth Held up Relatively Well During the 2008 Recession

Source: Daly et al. April 2012. 60

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

• n average between 2008 and 2011.

Hence real wage growth exceeded TFP growth by 0.45 percent per year, for a total of 1.35 percent over the period 2008-2011.

61

Assumption 1 The function γ(ut) satisfies γ′(ut) < 0, and γ(0) > ˜ βµ, where ˜ β ≡ βµ−σ. Assumption 2 The parameters R∗, π∗, and απ satisfy: R∗ ≡ π∗ ˜ β > 1, απ ˜ β > 1, π∗ > γ(0) µ .

62

Dynamics Effects of a Fundamental Shock Under the Exit Strategy

5 10 15 20 −15 −10 −5 5 10 Inflation % annual t 5 10 15 20 93 94 95 96 97 98 99 100 Employment Rate % t 5 10 15 20 1 2 3 4 5 6 7 Interest Rate % annual t 5 10 15 20 −20 −15 −10 −5 5 10 Output Growth Rate % annual t

Solid Line: Taylor Rule Dashed Line: Exit Strategy

63

Actual and Expected CPI Inflation, Japan, 1989-2001

1990 1992 1994 1996 1998 2000 −2 −1 1 2 3 4 5−year ahead Consensus Forecast Actual CPI Inflation Ex−post 5−year ahead CPI inflation CPI Inflation, y/y Year Percent Per Year

Data Sources. CPI: http://www.stat.go.jp/english/data/cpi/index.htm. Expected CPI In- flation from April and October survey of Consensus Forecast. 64