I develop a version of the New Keynesian model with insider-
outsider labor markets and hysteresis that can account for the high
persistence of European unemployment. I study the implications of
that environment for the design of monetary policy. The optimal policy
calls for strong emphasis on unemployment stabilization which a
standard interest rate rule fails to deliver, with the gap between the
two increasing in the degree of hysteresis. A simple interest rule that
includes the unemployment ...
I develop a version of the New Keynesian model with insider-
outsider labor markets and hysteresis that can account for the high
persistence of European unemployment. I study the implications of
that environment for the design of monetary policy. The optimal policy
calls for strong emphasis on unemployment stabilization which a
standard interest rate rule fails to deliver, with the gap between the
two increasing in the degree of hysteresis. A simple interest rule that
includes the unemployment rate is shown to approximate well the optimal policy.
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