Working Paper

Inflation and Unemployment in the Long Run


  • Berentsen
  • A.
  • Menzio
  • G.
  • Wright
  • R.
Publication Date

We study the long-run relation between money, measured by inflation or

interest rates, and unemployment. We first discuss data, documenting a

strong positive relation between the variables at low frequencies. We then

develop a framework where both money and unemployment are modeled

using explicit microfoundations, integrating and extending recent work in

macro and monetary economics, and providing a unified theory to analyze

labor and goods markets. We calibrate the model, to ask how monetary

factors account quantitatively for low-frequency labor market behavior.

The answer depends on two key parameters: the elasticity of money demand,

which translates monetary policy to real balances and profits; and

the value of leisure, which affects the transmission from profits to entry

and employment. For conservative parameterizations, money accounts for

some but not that much of trend unemployment — e.g. we can explain

around 20% of the increase in unemployment during the 70s stagflation

by monetary policy alone. For less conservative parameters, money accounts

for much of the low-frequency movement in unemployment over

the last half century, and explains between 68 and 86% of the increase in

unemployment during stagflation.