Monetary Policy and Unemployment in Open Economies

After an expansionary monetary policy shock employment increases and unemployment falls. In standard New Keynesian models the fall in aggregate unemployment does not a¤ect employed workers at all. However, Lüchinger, Meier and Stutzer (2010) found that the risk of unemployment negatively a¤ects utility of employed workers: An increases in aggregate unemployment decreases workers’subjective wellbeing, which can be explained by an increased risk of becoming unemployed. I take account of this e¤ect in an otherwise standard New Keynesian open economy model with unemployment as in Galí (2010) and …nd two important results with respect to expansionary monetary policy shocks: First, the usual wealth e¤ect in New Keynesian models of a declining labor force, which is at odds with the data as highlighted by Christiano, Trabandt and Walentin (2010), is shut down. Second, the welfare e¤ects of such shocks improve considerably, modifying the standard results of the open economy literature that set o¤ with Obstfeld and Rogo¤’s (1995) redux model. Keywords: Open economy macroeconomics, monetary policy, unemployment JEL classi…cation: E24, E52, F32, F41 Address: Freie Universität Berlin, Boltzmannstr. 20, 14195 Berlin, Germany, tel: +49-30-54632, email: [email protected]. A large part of the work on this paper was done during a visit to the National Centre of Econometric Research (NCER) at the School of Economics and Finance, Queensland University of Technology in Brisbane. I gratefully acknowledge the support and hospitality of my hosts, in particular Uwe Dulleck, and the support granted by the DAAD. I thank my discussant Gernot Müller and other participants of the Konstanz Seminar 2011 where I presented an earlier version of the paper for valuable comments and suggestions. I also thank Dominic Quint, Mathias Paustian, Wolfgang Strehl, Mathias Trabandt, Alexander Wul¤, and in particular Simon Lüchinger, for their comments and suggestions. Any errors, of course, are my own responsiblility.