Layoff Risk, the Welfare Cost of Business Cycles, and Monetary Policy

Abstract

The strongest predictor of changes in the Fed Funds rate in the period 1982–2008 was the layoff rate. That fact is puzzling from the perspective of representative-agent models of the economy, which imply that the welfare gains of stabilizing employment fluctuations are small. This paper augments a standard New Keynesian model with a labor market featuring countercyclical layoffs that lead to large,uninsurable, and permanent idiosyncratic wage declines. In our benchmark calibration, welfare may be increased by 1 percent of lifetime consumption or more when the central bank’s policy rule responds to the layoff rate instead of purely targeting inflation.