The Making Of A Great Contraction With A Liquidity Trap and A Jobless Recovery

Motivated by the recent experiences of the euro area and Japan, this paper presents a model that captures the joint occurrence of a liquidity trap and a jobless recovery. Its key elements are downward nominal wage rigidity, a Taylor-type interest-rate feedback rule, the zero bound on nominal rates, and a confidence shock. Absent a change in policy, the model predicts that low inflation and high unemployment become chronic. The paper considers a monetary policy that can lift the economy out of the slump. Specifically, it shows that raising the nominal interest rate to its intended target for an extended period of time, rather than exacerbating the recession as conventional wisdom would have it, can boost inflationary expectations and thereby foster employment. In an environment with capital accumulation, the jobless recovery takes place in the context of an investment slump.