Monetary Policy

(JOB MARKET PAPER) I develop a New Keynesian model with input-output linkages, search-and-matching frictions, and sticky prices to study how sector-specific shocks affect output and inflation. Firms draw workers from a common labor pool, creating a novel labor market propagation channel: higher demand in one sector raises wages and job-finding rates there, redirects job search, and increases hiring costs elsewhere. Solving the model nonlinearly shows that sectors’ importance for inflation and monetary policy is state-dependent—sectors with tighter labor markets raise prices more in response to demand or supply changes.The resulting Phillips curve steepens as tightness (vacancies over unemployment) rises, consistent with recent evidence, implying that monetary policy has larger effects on inflation but smaller effects on output when some sectors are tight.

In standard New Keynesian models, future interest rate cuts have larger effects than current cuts—this is called the forward guidance puzzle. We argue that the forward guidance puzzle is not a puzzle. We show the puzzle arises from an implausibly large monetary regime change, exceeding anything in U.S. history since the Great Depression. By calibrating our model to four regime changes during the U.S. Great Depression, disciplined by changes in long-term bond yields, we find the model’s predictions are broadly consistent with historical data.