Unemployment risk, liquidity traps, and monetary policy
Unemployment risk, liquidity traps, and monetary policy
We study optimal monetary policy in a model with incomplete markets, in the form of uninsurable unemployment risk, and an occasionally binding zero lower bound (ZLB) constraint. The optimal policy consists of keeping the nominal rate at zero longer than implied by current macroeconomic conditions. Such policy improves expected labour market conditions, substantially mitigating the rise in unemployment risk and precautionary savings. As a result, we find that market incompleteness does not significantly amplify contractions in output and inflation at the ZLB. However, when the central bank follows more realistic policy rules instead of the optimal policy, incomplete markets exacerbate the fall in demand, emphasising the importance of unemployment insurance for output stabilisation.
Bonciani, Dario
a2b065a5-415c-4554-8d3a-4087e80b7598
Oh, Joonseok
020d4770-4b18-4b76-bf81-d3e58b9f4eed
Bonciani, Dario
a2b065a5-415c-4554-8d3a-4087e80b7598
Oh, Joonseok
020d4770-4b18-4b76-bf81-d3e58b9f4eed
Bonciani, Dario and Oh, Joonseok
(2025)
Unemployment risk, liquidity traps, and monetary policy.
Journal of Economic Dynamics and Control, [105238].
(doi:10.1016/j.jedc.2025.105238).
Abstract
We study optimal monetary policy in a model with incomplete markets, in the form of uninsurable unemployment risk, and an occasionally binding zero lower bound (ZLB) constraint. The optimal policy consists of keeping the nominal rate at zero longer than implied by current macroeconomic conditions. Such policy improves expected labour market conditions, substantially mitigating the rise in unemployment risk and precautionary savings. As a result, we find that market incompleteness does not significantly amplify contractions in output and inflation at the ZLB. However, when the central bank follows more realistic policy rules instead of the optimal policy, incomplete markets exacerbate the fall in demand, emphasising the importance of unemployment insurance for output stabilisation.
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Unemployment Risk, Liquidity Traps, and Monetary Policy: Accepted
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Submitted date: 29 November 2025
Accepted/In Press date: 29 November 2025
e-pub ahead of print date: 5 December 2025
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Local EPrints ID: 507965
URI: http://eprints.soton.ac.uk/id/eprint/507965
ISSN: 0165-1889
PURE UUID: baef2d10-3296-4bbc-81d9-3e0c8cae7c31
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Date deposited: 08 Jan 2026 17:47
Last modified: 09 Jan 2026 03:05
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Author:
Dario Bonciani
Author:
Joonseok Oh
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