2013 LaborForceParticipationandMonet

• (Erceg & Levin, 2013) ⇒ Christopher J Erceg, and Andrew T Levin. (2013). “Labor Force Participation and Monetary Policy in the Wake of the Great Recession.” In: Manuscript, International Monetary Fund, April Journal, 9.

Subject Headings: U.S Labor Force Participation Rate; U.S. Monetary Policy

Cited By

• http://scholar.google.com/scholar?q=%22Labor+Force+Participation+and+Monetary+Policy+in+the+Wake+of+the+Great+Recession%22+2013

Quotes

Author Keywords

• labor force; policy tradeoffs; simple rules; unemployment rate

Abstract

In this paper, we provide compelling evidence that cyclical factors account for the bulk of the post-2007 decline in the U.S. labor force participation rate. We then proceed to formulate a stylized New Keynesian model in which labor force participation is essentially acyclical during "normal times" (that is, in response to small or transitory shocks) but drops markedly in the wake of a large and persistent aggregate demand shock. Finally, we show that these considerations can have potentially crucial implications for the design of monetary policy, especially under circumstances in which adjustments to the short-term interest rate are constrained by the zero lower bound.

1. Introduction

A longstanding and well-established fact in labor economics is that the labor supply of prime-age and older adults has been essentially acyclical throughout the postwar period, while that of teenagers has been moderately procyclical; cf. Mincer (1966), Pencavel (1986), and Heckman and Killingsworth (1986). Consequently, macroeconomists have largely focused on the unemployment rate as a business cycle indicator while abstracting from movements in labor force participation. Similarly, the literature on optimal monetary policy and simple rules has typically assumed that unemployment gaps and output gaps can be viewed as roughly equivalent; cf. Orphanides (2002), Taylor and Williams (2010).

In this paper, we reconsider such conventional wisdom in light of labor market developments since the Great Recession. As shown in Figure 1, the labor force participation rate has fallen about 2-1/2 percentage points ña striking contrast to the modest decline that was projected by the Bureau of Labor Statistics in November 2007 just prior to the onset of the recession. Given the dropo§ in labor force participation, the employmentñto-population ratio has remained close to its pre-crisis trough even as the unemployment rate has returned roughly halfway back from its peak.

Our paper provides compelling empirical evidence that cyclical factors account for the bulk of the recent decline in the labor force participation rate (henceforth LFPR). We then proceed to formulate a stylized New Keynesian model in which householdsílabor market exit and reentry decisions are associated with significant adjustment costs. Our model analysis highlights how policy rules that respond to broader measures of labor market slack that include the cyclical component of participation may have very di§erent implications for how the economy recovers from a deep recession than ìstandardîrules that focus on the unemployment gap.

More specifically, our analysis of state-level employment data indicates that cyclical factors can fully account for the post-2007 decline of 2 percentage points in the LFPR for prime-age adults (that is, 25 to 54 years old). We define the participation gap as the deviation of the LFPR from its trend path as implied solely by demographic considerations, and we find that as of early 2013 this gap stood at around 2 percentó roughly the same magnitude as the unemployment gap (that is, the deviation of unemployment from its longer-run normal rate). Indeed, our analysis suggests that the participation gap and the unemployment gap each account for roughly half of the current employment gap, that is, the shortfall of the employment-to-population rate from its pre-crisis trend.

Our empirical analysis is broadly consistent with a number of other recent studies. Aaronson, Davis and Hu (2012) estimated statistical models for 44 demographic groups (based on age, gender, and educational attainment), incorporating birth cohort e§ects and other controls, and showed that only one-fourth of the decline in the LFPR since 2008 was attributable to demographic factors. Using a multivariate Beveridge-Nelson decomposition, Van Zandweghe (2012) found that cyclical factors accounted for 50 to 90 percent of the decline in the LFPR, depending on which measure of unemployment was used in constructing the filter. Sherk (2012) analyzed micro data from the Current Population Survey (CPS) and found that demographic factors only accounted for one-fifth of the post-recession decline in LFPR. Finally, Hotchkiss and Rios-Avila (2013) estimated a behavioral model of labor supply using CPS micro data and concluded that the decline in LFPR since the Great Recession was more than fully explained by the deterioration in labor market conditions.

We develop a simple extension of the workhorse New Keynesian model (e.g., Woodford 2003) that can account qualitatively for the stylized facts that: i) decreases in labor force participation appear relatively modest in most post-war recessions, but ii) protracted recessions may eventually induce large declines in participation. Our model implies that labor force participation responds inversely to the unemployment rate, but that the response is gradual due to high adjustment costs of moving between the market and "home production" sectors. In normal recessions that are fairly transient in duration, the employment gap is largely driven by sharp but short-lived movements in the unemployment rate: labor force participation doesnít move much due to adjustment costs. However, a deep and protracted recession may eventually cause a sizeable decline in the LFPR. Importantly, to the extent that labor force participation responds very gradually to the unemployment rate, labor force participation may remain well below trend even as the economy begins recovering and the unemployment gap closes.

A second key feature of our model is that the labor force participation gap enters the Phillips Curve in addition to the unemployment gap. A large negative participation gap induces labor force participants to reduce their wage demands, although our calibration implies that the participation gap has much less influence than the unemployment rate quantitatively. An important implication of this modified Phillips Curve is that inflation would remain below baseline following a recession even after the unemployment gap is closed, at least while the participation gap remains negative.

The possibility that deep recessions may generate large cyclical swings in labor force participation has important implications for monetary policy design: should monetary policy respond to the cyclical component of labor force participation in some way, or focus more exclusively on the unemployment rate as suggested by a large literature focused on the Great Moderation? To address this question, we use our model to analyze several alternative monetary policy strategies against the backdrop of a deep recession that leaves labor force participation well below its long-run potential level. In our simulations, the deep recession reáects that the zero lower bound precludes monetary policy from lowering policy rates enough to o§set a negative aggregate demand shock; once the shock dies away su¢ ciently, policy responds according to a non-inertial Taylor rule.

would remain below baseline following a recession even after the unemployment gap is closed, at least while the participation gap remains negative. 4 The possibility that deep recessions may generate large cyclical swings in labor force participation has important implications for monetary policy design: should monetary policy respond to the cyclical component of labor force participation in some way, or focus more exclusively on the unemployment rate as suggested by a large literature focused on the Great Moderation? To address this question, we use our model to analyze several alternative monetary policy strategies against the backdrop of a deep recession that leaves labor force participation well below its long-run potential level. In our simulations, the deep recession reflects that the zero lower bound precludes monetary policy from lowering policy rates enough to o§set a negative aggregate demand shock; once the shock dies away sufficiently, policy responds according to a non-inertial Taylor rule. A key result of our analysis is that a monetary policy can induce a more rapid closure of the participation gap through allowing the unemployment rate to overshoot its long-run natural rate (i.e,. unemployment falls below the natural rate). Quite intuitively, keeping unemployment persistently low draws cyclical non-participants back into labor force more quickly. Given that the cyclical non-participants exert some downward pressure on inflation, some overshooting of the long-run natural rate actually turns out to be consistent with keeping inflation stable in our model. However, a more aggressive strategy of employment gap targeting boosts inflation - at least to some degree - by requiring unemployment to remain lower for even longer. Thus, there is some tradeoff between stabilizing inflation and broad measures of resource slack that include participation.

Policy rules that respond to broad measures of labor market slack share some characteris- tics of optimal "full commitment" policy strategies insofar as both imply some overshooting of the unemployment rate and inflation as the economy recovers. Even so, we stress that the …

References

;

	Author	volume	Date Value	title	type	journal	titleUrl	doi	note	year
2013 LaborForceParticipationandMonet	Christopher J Erceg Andrew T Levin			Labor Force Participation and Monetary Policy in the Wake of the Great Recession