Optimal monetary policy in the presence of human capital depreciation during unemployment

The recession and associated rise in unemployment has helped to revive interest in studying the trade-off that monetary policy makers face between unemployment and inflation stabilisation. But the literature has focused primarily on an environment where all workers have the same characteristics, leaving it an open question whether this trade-off is altered once worker heterogeneity is taken into account. This paper analyses this trade-off in an environment where human capital depreciation during unemployment generates heterogeneity among ex-ante identical workers. Introducing human capital depreciation during unemployment into an otherwise standard New Keynesian model incorporating sticky prices and other features including search frictions in the labour market leads to the finding that the flexible-price allocation is no longer efficient even when the Hosios condition holds.