Labor Supply Shocks, Labor Force Entry, and Monetary Policy

Should monetary policy offset the effects of labor supply shocks on inflation and the output gap? Canonical New Keynesian models answer yes. Motivated by weak labor force participation during the pandemic, we reexamine the question by introducing labor force entry and exit in an otherwise canonical model with sticky prices and wages. The entry decision generates an employment channel of monetary policy, by which a decline in employment raises wage growth. Consequently, a labor supply shock to the value of nonparticipation in the labor market induces a policy trade-off between stabilization of the employment gap and wage growth. For an adverse labor supply shock, optimal policy dampens the decline in employment to rein in wage growth, which entails a period of higher inflation and a positive output gap. A welfare analysis of policy rules shows that monetary policy should not lean against the employment gap.