How should monetary policy respond to a contraction in labor supply? Not the way conventional models prescribe, according to Cleveland Fed analysis

New research from the Federal Reserve Bank of Cleveland challenges the conventional wisdom that a central bank should offset the inflationary effects of a surprise decline in labor supply.

In the Economic Commentary, “How Should Monetary Policy Respond to a Contraction in Labor Supply?” researchers include labor force entry and exit into an otherwise standard model for monetary policy analysis. They find that including labor force entry and exit in the model alters the policy prescription for dealing with labor supply shocks.

“Our analysis indicates that central banks should respond to a labor supply shock that lowers the natural rate of employment by letting employment adjust partially, thereby mitigating a decline in labor supply that puts upward pressure on wage growth and inflation,” write Takushi Kurozumi and Willem Van Zandweghe. “The optimal policy overturns the conventional wisdom that central banks can and should completely offset the inflationary effects of such a shock, obtained in textbook models that abstract from labor force entry and exit.”

Read more: How Should Monetary Policy Respond to a Contraction in Labor Supply?

Federal Reserve Bank of Cleveland

The Federal Reserve Bank of Cleveland is one of 12 regional Reserve Banks that along with the Board of Governors in Washington DC comprise the Federal Reserve System. Part of the US central bank, the Cleveland Fed participates in the formulation of our nation’s monetary policy, supervises banking organizations, provides payment and other services to financial institutions and to the US Treasury, and performs many activities that support Federal Reserve operations System-wide. In addition, the Bank supports the well-being of communities across the Fourth Federal Reserve District through a wide array of research, outreach, and educational activities.

The Cleveland Fed, with branches in Cincinnati and Pittsburgh, serves an area that comprises Ohio, western Pennsylvania, eastern Kentucky, and the northern panhandle of West Virginia.

Media contact

Doug Campbell, doug.campbell@clev.frb.org, 513.218.1892