Clashing Theories: Why Is Unemployment So High When Interest Rates Fall to Zero?∗

General-equilibrium models for studying the zero lower bound on the nominal interest rate contain implicit theories of unemployment. In some cases, the theory is explicit. When the nominal rate is above the level that clears the current market for output, the excess supply shows up as diminished output, lower employment, and higher unemployment. Quite separately, the Diamond-Mortensen-Pissarides model is a widely accepted and well-developed account of turnover, wage determination, and unemployment. The standard DMP model is a clashing theory of unemployment, in the sense that its determinants of unemployment do not include any variables that signal an excess supply of current output. Altering the DMP model by allowing the rate of inflation to influence unemployment, as several authors have proposed, resolves the clash. I derive the condition needed to achieve the resolution when the zero lower bound is binding and thus to explain high unemployment in recent years. The condition implies that stale nominal values have a strong effect on the wages of new hires. It appears to be satisfied by existing models and is supported by the small decline in inflation that has occurred in the U.S. between 2007 and 2009.