Asymmetric unemployment fluctuations and monetary policy trade-offs

Abstract

I show that a quantitatively significant trade-off between inflation and unemployment stabilization arises in New Keynesian models with search and matching frictions in the labor market when both steady-state distortions and the elasticity of labor market tightness with respect to productivity are large. The first condition implies that variations in average unemployment matter for welfare outcomes. In combination with the unemployment asymmetries built in the search and matching framework, the second condition entails that average unemployment is substantially higher in an economy with business cycles than in steady state. In this environment, the central bank has an incentive to tolerate some inflation volatility in response to shocks since doing so reduces unemployment volatility and average unemployment. Most of the welfare gains obtained by the optimal policy derive from this effect on the average level of unemployment.