Wage rigidities and jobless recoveries

Real wage rigidities cause jobless recoveries. Suppose that a one-time shock reduces the capital stock below trend. If wages are flexible, they decline and employment increases at the moment of the shock, before both revert back to normal levels as the economy grows back to trend. If wages are completely rigid and the labor market is otherwise frictionless, the shock causes a proportional and permanent decline in employment, capital, output, consumption, and investment relative to trend. In a search model with rigid wages, the shock causes a persistent but not permanent decline in these economic outcomes, a jobless recovery.

► During the recovery, output, consumption, and employment are low as well. ► This is true in a frictionless model where labor demand determines employment. ► This is true in a search model where rigid wages are individually rational.