Supply shocks, employment gap, and monetary policy

Takushi Kurozumi and Willem Van Zandweghe

European Economic Review, 2025, vol. 177, issue C

Abstract: How should monetary policy respond to supply shocks in terms of inflation and employment stabilization? We introduce labor force entry and exit in an otherwise standard model with staggered price- and wage-setting to include employment in the model. A welfare-maximizing policy features wage growth stabilization with variation in the employment gap and inflation. Under staggered price- and wage-setting, the real wage adjustments to shocks entail a welfare cost, and variation in the employment gap contributes to reducing the welfare cost. Therefore, leaning against the employment gap induces substantial welfare losses for supply shocks compared to the welfare-maximizing policy.

Keywords: Labor force entry and exit; Extensive margin of labor; Staggered price- and wage-setting; Wage growth stabilization (search for similar items in EconPapers)
JEL-codes: E24 E31 E52 J21 (search for similar items in EconPapers)
Date: 2025
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Working Paper: Supply Shocks, Employment Gap, and Monetary Policy (2025)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:eecrev:v:177:y:2025:i:c:s0014292125000996

DOI: 10.1016/j.euroecorev.2025.105049

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