QE and Unemployment: A Financial Friction DSGE Model with LSAPs and Labor Market Search

Abstract

In response to the disruption of credit markets and the zero lower bound during the recent financial crisis, the Federal Reserve introduced a variety of new policy tools. Perhaps, the most visible of these tools is large scale asset purchases (LSAP) programs, often referred to as "quantitative easing" (QE). Among the policy objectives, unemployment rate is a crucial target to the central bank. However, exactly which factors could account for the impact of QE programs on unemployment has yet to be resolved. Also, agreement on the effectiveness of QE has stimulated the economic recovery is far from universal. This paper is to have a financial friction DSGE model with labor market search to assess the impact of regime switching between conventional and unconventional monetary policy on aggregate economic activity, especially on labor market, and to evaluate the effect of QE policy on the unemployment rate during the recent recession. The paper reveals channels through which the credit policy shocks transmit to labor market and the impacts of financial shock is amplified. The paper finds that bond purchasing policy has stronger effect on labor market and the security purchase policy creates more volatility to the unemployment rate. Both policies have effective short-run effect yet ineffective even negative long-run effect. Also, timing effects of asset purchase policy reactions are different.

Keywords: Quantitative Easing, Financial Friction, Unemployment, Regime Switch

JEL Classification: E24, E42, E44, E58