NCER Working Paper Series 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.