Hysteresis, financial frictions and monetary policy

This paper develops a medium-sized monetary DSGE model of unemployment which assumes asymmetric information between entrepreneurs and financial intermediaries resulting in costly state verification financial frictions. The labor sector of the model consists of an insiders-outsiders labor market structure where a monopoly labor union unilaterally sets the nominal wage according to a hysteresis equation. Labor market hysteresis generates an asymmetry between insiders and outsiders. The main purpose of the paper is, firstly, to explore how labor market hysteresis affects the persistence of macroeconomic aggregates after temporary aggregate shocks that simulate a financial crisis; secondly, to investigate the implications of hysteresis for monetary policy. Overall, it is highlighted that a DSGE model that incorporates both financial frictions and employment hysteresis can generate substantial endogenous persistence that resemble a severe financial crisis. Furthermore, welfare analysis indicates a Taylor policy that stabilizes the growth rate of output leads to heavy welfare losses relative to output gap targeting. These losses increase with the degree of hysteresis. In this case, a central bank can benefit from choosing to stabilize wage inflation.