Working Paper
Inflation and Unemployment in the Long Run
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.