LFPR

WP/13/245
Labor Force Participation and Monetary Policy

in the Wake of the Great Recession
Christopher J. Erceg and Andrew T. Levin
© International Monetary Fund WP/13/245
IMF Working Paper
Research
Labor Force Participation and Monetary Policy in the Wake of the Great Recession
Prepared by Christopher J. Erceg and Andrew T. Levin*
Authorized for distribution by Prakash Loungani
July 2013
This Working Paper should not be reported as representing the views of the IMF.
The views expressed in this Working Paper are those of the author(s) and do not necessarily
represent those of the IMF or IMF policy. Working Papers describe research in progress by the
author(s) and are published to elicit comments and to further debate.
Abstract
In this paper, we provide compelling evidence that cyclical factors account for the bulk of the
post-2007 decline in the U.S. labor force participation rate. We then proceed to formulate a
stylized New Keynesian model in which labor force participation is essentially acyclical during
“normal times” (that is, in response to small or transitory shocks) but drops markedly in the wake
of a large and persistent aggregate demand shock. Finally, we show that these considerations can
have potentially crucial implications for the design of monetary policy, especially under
circumstances in which adjustments to the short-term interest rate are constrained by the zero
lower bound.
JEL Classification Numbers: E24, E32, E52, J21

Keywords: labor force participation, unemployment, and monetary policy rules
Author’s E-Mail Address: cerceg@imf.org; alevin@imf.org
_________________________
*The authors are currently on leave from the Federal Reserve Board as visitors in the research department at the
International Monetary Fund and may be contacted as follows-Erceg: 202-623-4564, email cerceg@imf.org ;
Levin: phone 202-623-9648, email alevin@imf.org . In the course of preparing this paper, we have appreciated
very helpful comments and suggestions from George Akerlof, Olivier Blanchard, Olivier Coibion, Mary Daly, Tim
Fuerst, Jeff Fuhrer, Bart Hobijn, Andreas Hornstein, Prakash Loungani, Athanasios Orphanides, Lars Svensson,
and Kenneth West. The views expressed in this paper are solely those of the authors and do not necessarily reflect
th eviews of the International Monetary Fund, the Board of Governors of the Federal reserve System, or any other
person associated with the Federal Reserve System.
1/<9-
)*79 )93-; -=-4785-6;: 16 ;0- ()3- 7. ;0- 9-); #-+-::176
Percent Percent
68 66 12
Labor Force Participation Rate Employment-Pop. Ratio (left scale)
BLS forecast (Nov2007) Unemployment Rate (right scale)
67
64 10
66
62 8
65
60 6
64
63 58 4
2004 2006 2008 2010 2012 2008 2009 2010 2011 2012 2013
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1/<9- -57/9)801+ %9-6,: 16 )*79 79+- !)9;1+18);176
;7
Male Female
100 Percent
80
60
40
16 to 24 yrs
20 25 to 54 yrs
55 and older
0
1950 1960 1970 1980 1990 2000 1950 1960 1970 1980 1990 2000
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Unemployment Rate Labor Force Participation Rate

Percent
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0.3 0.3
0.2 0.2
0.1 0.1
0.0 0.0
-0.1 -0.1
-0.2 -0.2
4 8 12 16 20 4 8 12 16 20
Number of Quarters Number of Quarters
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Regression Line
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0 TX
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Change in Unemployment
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1/<9- %0- 6+1,-6+- 7. !-95)6-6; 1:)*141;1-:
Prime-Age Adults Older Adults

(25 to 54 years) (55 to 64 years) Percent
4 12
Pre-Crisis Trend
3 11
2 10
1 9
03
04
05
06
07
08
09
10
11
04
05
06
07
08
09
10
11
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
Percent
1.2 4
Regression Line
1.0
MI
Change in Disability Rate
Change in Disability Rate
3
0.8
0.6 2
0.4
NY
o
FL NV
1
0.2 TX IL
CA NV
0.0 0
0 2 4 6 8 10 0 2 4 6 8 10
Change in Unemployment Rate Change in Unemployment Rate
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1/<9- %0- )/61;<,- )6, 7587:1;176 7. ;0- 5847@5-6; )8
Percent
6
Employment Gap
Participation Gap
5 Unemployment Gap
0
2008 2009 2010 2011 2012 2013
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Figure 7: Monetary Policy Tightening
Transient Tightening
0
-0.1
-0.2
-0.3
-0.4
-0.5
-0.6 Overall Employment Gap

Participation Gap
-0.7
0 4 8 12 16
Persistent Tightening
0
-0.5
-1
-1.5
-2
-2.5
0 4 8 12 16
Figure 8: Adverse Demand Shock under Different Monetary Rules
Unemployment Gap Participation Gap

10 0
5 -1
Percent
Percent
0 -2
-5 -3
0 8 16 24 32 0 8 16 24 32
Nominal Interest Rate (APR) Inflation

4 2.5
2 2
Percent
Percent
0 1.5
-2 1
0 8 16 24 32 0 8 16 24 32
Overall Employment Gap Potential Real Interest Rate (APR)

5 2
0
0
Percent
Percent
-2
Inflation Targeting
-5
-4 Overall Employment Gap Targeting
Unemployment Rate Targeting
-10 -6
0 8 16 24 32 0 8 16 24 32
Figure 9: Adverse Demand Shock under Different Rules: Faster Participation Response

4 0
2 -1
Percent
Percent
0 -2
-2 -3
0 8 16 24 32 0 8 16 24 32

4 2.4
2.2
2
Percent
Percent
2
0
1.8
-2 1.6
0 8 16 24 32 0 8 16 24 32

0 2
0
-2
Percent
Percent
-2
-4
-4 Employment Gap Targeting
Unemployment Rate Targeting
-6 -6
0 8 16 24 32 0 8 16 24 32
Figure 10: Adverse Demand Shock w/Different Phillips Curve Slopes

4 0
-0.2
2
Percent
Percent
-0.4
0
-0.6
-2 -0.8
0 8 16 24 32 0 8 16 24 32

4 3
2 2.5
Percent
Percent
0 2
-2 1.5
0 8 16 24 32 0 8 16 24 32

0 2
-1 0
Percent
Percent
-2 -2
-3 -4 Faster Price Adjustment

Benchmark Calibration
-4 -6
0 8 16 24 32 0 8 16 24 32
Figure 11: Different Coefficients on Participation Gap under Employment Gap Targeting

4 0
2
Percent
Percent
-0.5
0
-2 -1
0 8 16 24 32 0 8 16 24 32

4 2.6
2.4
2
Percent
Percent
2.2
0
2
-2 1.8
0 8 16 24 32 0 8 16 24 32

0 2
-1 0
Percent
Percent
-2 -2
Equal Coeff on Participation Gap
-3 -4 Benchmark
Tiny Coeff on Participation Gap
-4 -6
0 8 16 24 32 0 8 16 24 32
Figure 12. Comparison of Employment Gap Targeting and Optimal Policy

4 0.5
2 0
Percent
Percent
0 -0.5
-2 -1
0 8 16 24 32 0 8 16 24 32

4 2.6
2.4
2
Percent
Percent
2.2
0
2
-2 1.8
0 8 16 24 32 0 8 16 24 32

2 2
0
0
Percent
Percent
-2
-2
-4 Optimal Policy
Benchmark (Taylor Rule)
-4 -6
0 8 16 24 32 0 8 16 24 32
Appendix Figure A1: The Demographic Composition of the Labor Force, 1948 to 2012
Percent
100
80
60
40
Prime-Age Males
20 Prime-Age Females
Youths
Older Adults
0
1950 1960 1970 1980 1990 2000 2010
Note: This figure depicts the demographic composition of the labor force (in percent) from 1948 to 2012.
The solid area denotes the share of prime-age males (25 to 54 years old), and the horizontal-dashed area denotes
the share of prime-aged females (25 to 54 years). The diagonal-dashed and vertical-dashed areas denote the shares
for youths (16 to 24 years) and older adults (55 years and above), respectively. Source: Bureau of Labor Statistics.
Appendix Figure A2: The Cyclical Dynamics of the LFPR During “ormal Times”
by Age Group
Unemployment Rate Prime-Age LFPR (25 to 54 years)

Percent
0.4 0.4
0.2 0.2
0.0 0.0
-0.2 -0.2
5 10 15 20 5 10 15 20
Youth LFPR (16 to 24 years) Older Adults LFPR (55 years & above)
0.4 0.4
0.2 0.2
0.0 0.0
-0.2 -0.2
5 10 15 20 5 10 15 20
Note: This figure depicts the impulse responses from a VAR estimated using quarterly data on the unemployment
rate and the labor force participation rates for three demographic groups (prime-age adults, youths, and older adults)
over the period 1948:Q1 to 2007:Q4. In each panel, the solid line denotes the response of the specified variable
to an orthogonalized unemployment rate shock of one standard deviation, and the dashed lines depict 95 percent
confidence bands based on 10,000 Monte Carlo replications.
Appendix Figure A3: Labor Force Participation Rates by Gender and Age
Males, 16 to 24 Years Females, 16 to 24 Years

66 60
BLS forecast (ov2007)
64
58
62
60 56
58
54
56
54 52
2004 2006 2008 2010 2012 2004 2006 2008 2010 2012
Males, 25 to 54 Years Females, 25 to 54 Years

92 76
91
75
90
74
89
88 73
2004 2006 2008 2010 2012 2004 2006 2008 2010 2012
Males, 55 Years and Older Females, 55 Years and Older

48 38
47
36
46
45 34
44
32
43
42 30
2004 2006 2008 2010 2012 2004 2006 2008 2010 2012
Note: In each panel, the solid line denotes the actual evolution of the labor force participation rate (in percent)
for the specified demographic group from 2004:Q1 to 2013:Q1, and the dashed line denotes the linear trend for
the decade ending in 2016 that was projected by BLS staff and published in the November 2007 issue of the
Monthly Labor Review. Source: Bureau of Labor Statistics.
Appendix Figure A4: Data from Larger States (excluding evada)
Regarding Unemployment and Labor Force Participation of Prime-Age Adults
2
Regression Line
Change in Labor Force Participation
-1
-2
-3
-4
-5
0 1 2 3 4 5 6 7 8 9 10
Change in Unemployment
Note: The vertical axis refers to the change in the labor force participation rate for prime-age adults (25 to 54 years)
between 2007 and 2012, and the horizontal axis refers to the change in the unemployment rate for that demographic
group between 2007 and 2010. The observations correspond to 40 states that had more than 500,000 prime-age
adults as of December 2007; i.e., this sample excludes Nevada (for reasons discussed in the text) as well as Alaska,
Delaware, Hawaii, Montana, North Dakota, Rhode Island, South Dakota, Vermont, Wyoming, and Washington DC.
The dashed line depicts the regression obtained using these 40 data points. Source: Bureau of Labor Statistics.
Appendix Figure A5: Gauging the Degree of Attachment to the Labor Force
Percent
2.5
Participation Gap
2.0 Marginally Attached
Discouraged
1.5
1.0
0.5
0.0
2008 2009 2010 2011 2012 2013
Note: The solid line denotes the deviation between the actual LFPR and its trend path as projected by the BLS in
November 2007. The short-dashed and long-dashed lines denote the post-2007 changes in the incidence of
“discouraged” job-seekers and in the incidence of individuals who are “marginally attached” to the labor force,
respectively, measured as a share of the civilian noninstitutionalized population aged 16 and above. “Marginally
attached” refers to persons not in the labor force who want a job, are available now, and have looked for work
sometime in the past year but not in the past month. “Discouraged” refers to persons not in the labor force who
want a job and are available now and who have looked for work sometime in the past year but who are not currently
searching because they believe there are no jobs available for which they would qualify

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WP/13/245

Labor Force Participation and Monetary Policy

IMF Working Paper

Prepared by Christopher J. Erceg and Andrew T. Levin*

Authorized for distribution by Prakash Loungani

JEL Classification Numbers: E24, E32, E52, J21

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Nominal Interest Rate (APR) Inflation

Overall Employment Gap Potential Real Interest Rate (APR)

Unemployment Gap Participation Gap

Nominal Interest Rate (APR) Inflation

Overall Employment Gap Potential Real Interest Rate (APR)

Unemployment Gap Participation Gap

Nominal Interest Rate (APR) Inflation

Overall Employment Gap Potential Real Interest Rate (APR)

-3 -4 Faster Price Adjustment

Unemployment Gap Participation Gap

Nominal Interest Rate (APR) Inflation

Overall Employment Gap Potential Real Interest Rate (APR)

Unemployment Gap Participation Gap

Nominal Interest Rate (APR) Inflation

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