A single monetary policy for heterogeneous labour markets : the case of the euro area.
Date: 2023-01-30
Institutions: European Central Bank
Subjects: euro area, household consumption, inflation, labour market, monetary policy, monetary union, unemployment

Sandra Gomes, Pascal Jacquinot, Matija Lozej 

Working Paper Series 

A single monetary policy for 
heterogeneous labour markets: 
the case of the euro area 

No 2769 / January 2023 

Disclaimer: This paper should not be reported as representing the views of the European Central Bank 
(ECB). The views expressed are those of the authors and do not necessarily reflect those of the ECB. 

Abstract

Differences in labour market institutions and regulations between countries of the mon-

etary union can cause divergent responses even to a common shock. We augment a multi-

country model of the euro area with search and matching framework that differs across

Ricardian and hand-to-mouth households. In this setting, we investigate the implications of

cross-country heterogeneity in labour market institutions for the conduct of monetary policy

in a monetary union. We compute responses to an expansionary demand shock and to an

inflationary supply shock under the Taylor rule, asymmetric unemployment targeting, and

average inflation targeting. For each rule we distinguish between cases with zero weight on

the unemployment gap and a negative response to rising unemployment. Across all rules,

responding to unemployment leads to lower losses of employment and higher inflation. Re-

sponding to unemployment reduces cross-country differences within the monetary union and

the differences in consumption levels of rich and poor households.

JEL Classification: E24, E32, E43, E52, F45

Keywords: DSGE Modelling, Business cycles, Search and matching, Monetary Union

ECB Working Paper Series No 2769 / January 20231Non-technical summary

Two of the world’s largest central banks, the European Central Bank and the Federal Reserve

have recently conducted a review of their monetary policy strategies. A common feature of

both strategy reviews was the considerable attention paid to employment-related issues. Distri-

butional issues were an important consideration and both central banks produced background

documents that looked at heterogeneity, either between households or among countries in the

monetary union.

In the euro area, the heterogeneity dimension is not only important across households, but

also across countries within the monetary union. This is particularly the case for labour markets,

which are less integrated than those of the US and are governed by country-specific legislations.

Differences in labour market institutions between countries of the monetary union can give rise

to different responses to shocks across countries, even when the shocks hit all monetary union

regions symmetrically. Our paper provides an analytical framework that addresses both cross-

country and within-country labour market heterogeneity in a monetary union. In particular,

we develop and use a new version of the Euro Area within the GLobal Economy model (the

EAGLE model), a large-scale open-economy model that is augmented with an enhanced labour

market, modelled using search-and-matching frictions. Each country is modelled as a two-

agent New Keynesian model (a so-called TANK model) with Ricardian (“wealthy”) and non-

Ricardian (“poor”) households. Each type of agent faces a labour market with its own particular

characteristics regarding job finding and separation rates, bargaining power, and nominal wage

rigidity. The latter is modelled so that it allows distinguishing wage stickiness for new hires and

for existing employees. Importantly, because non-Ricardian households are constrained in terms

of consumption smoothing, their consumption depends mainly on their labour income, which in

turn depends on the labour market situation for these households.

We use the model to study the implications of cross-country heterogeneity for the conduct of

monetary policy in a monetary union. We first compute responses to a common expansionary

demand shock, which increases inflation and reduces unemployment, across the monetary union

under three different monetary policy rules: a benchmark Taylor rule that includes a response

to inflation and unemployment, a Taylor rule that includes an asymmetric response to unem-

ployment, and average inflation targeting rule. For all these three rules, we distinguish between

cases where the central bank does not respond to unemployment and the cases where it does.

ECB Working Paper Series No 2769 / January 20232We next compute the responses to an inflationary supply shock, which increases both inflation

and unemployment. For each type of shock, we compare the performance of rules in terms

of inflation and employment stabilisation, and in terms of cross-country and cross-household

heterogeneity within the monetary union.

We find that when monetary policy responds to unemployment developments, then this

results in stronger unemployment decrease after expansionary demand shocks and lower unem-

ployment increase after a contractionary supply shock. While this does lead to a faster and

stronger increase in inflation, it also results in a fast return of inflation to lower levels after the

supply shock. Responding to unemployment tends to lower inequality between and within coun-

tries of the euro area. If monetary policy ignores unemployment and responds only to inflation,

this leads to larger fluctuations of output and (un)employment. Moreover, these fluctuations in-

crease divergence between the euro area economies as well as within-economy divergence among

households. The effect on between-household consumption differences is, however, different for

expansionary and contractionary shocks. When the central bank does not respond to unemploy-

ment, the difference between consumption of different types of households goes in favour of the

poor households after an expansionary demand shock, while after an inflationary supply shock

this difference goes in favour of richer households.

ECB Working Paper Series No 2769 / January 202331 Introduction

Two major central banks, the European Central Bank (ECB) and the Federal Reserve (FED)

have recently conducted a review of their monetary policy strategies.1 A feature of both strategy

reviews was that they paid considerable attention to employment-related issues, even when this

is not mandated by the law, as is the case of the ECB. The FED examined the relation between

monetary policy strategy and employment outcomes, see e.g. Feiveson et al. (2020), and the

ECB launched the Workstream on Employment that looked at similar issues in the euro area,

see Brand et al. (2021).

Both of these background documents looked at heterogeneity, either between households or

among countries in the monetary union. Distributional issues were an important factor in both

cases. Chairman Powell explicitly stated that “Our revised statement reflects our appreciation of

a strong labour market, particularly for many in low- and moderate-income communities.” (Pow-

ell, 2020). The ECB similarly mentions concern for heterogeneity by stating “...the medium-term

orientation provides flexibility to take account of employment in response to economic shocks,

giving rise to a temporary trade-off between short-term employment and inflation stabilisation

without endangering medium-term price stability.” and “... important to [...] account for uncer-

tainty, heterogeneity and ongoing structural changes shaping the outlook for economic activity

and employment in the euro area and its member countries.” (ECB, 2021).

In the euro area, the heterogeneity dimension is not only important across households, but

also across countries, and this is particularly the case for labour markets, which are less inte-

grated than those of the US and are governed by country-specific legislations. These differences

in labour market institutions and regulations between countries of the monetary union can give

rise to heterogeneous responses across countries, even in response to a common shock. Our paper

provides an analytical framework that addresses both cross-country and within-country labour

market heterogeneity in a monetary union. In particular, we develop and use a new version of

the Euro Area within the GLobal Economy model (the EAGLE model), augmented with an en-

hanced labour market that is modelled using search-and-matching frictions as in Mortensen and

Pissarides (1999) in all blocs. Each country is modelled as a two-agent New Keynesian model

(a so-called TANK model) with Ricardian (“wealthy”) and non-Ricardian (“poor”) households.

Each type of agent faces a labour market with its own particular characteristics regarding job

1The Federal Reserve conducted its strategy review in 2019/2020, and the ECB in 2020/2021.

ECB Working Paper Series No 2769 / January 20234finding and separation rates, bargaining power, and wage rigidity. The latter is modelled follow-

ing the approach of Bodart et al. (2006) and de Walque et al. (2009), which allows distinguishing

wage stickiness for new hires and for existing employees. Importantly, because non-Ricardian

households are constrained in terms of consumption smoothing, their consumption depends on

their labour income, which in turn depends on the labour market situation for these households.

The presence of non-Ricardian households and different characteristics of the labour market

they face are important, as recent evidence has suggested that labour markets do not exhibit

the same properties across the entire wealth (or earnings) distribution. A typical finding is that

labour market outcomes in terms of employment and hours worked tend to be more volatile

at the left tail of the distribution. See, for instance, Guvenen et al. (2017), Cair´o and Cajner

(2018), Amberg et al. (2022), Broer et al. (2022), Herman and Lozej (2021) and Cantore et al.

(2022), who all document higher volatility at the left tail of the labour market in terms of wealth

(even though this may not always be for the same reason). Higher labour market volatility at

the bottom of the distribution, where most income is from labour earnings and where marginal

propensity to consume is high, can have material aggregate implications, as it increases the

volatility of aggregate consumption.

After calibrating the model to capture cross-country and cross-household labour market

characteristics, we then use the model to study the implications of cross-country heterogeneity

in labour market institutions for the conduct of monetary policy in a monetary union. We

first compute responses to a common expansionary demand shock across the monetary union

under three different monetary policy rules: a benchmark Taylor rule that includes a response

to inflation and unemployment (IT rule), a Taylor rule that includes an asymmetric response

to unemployment (ASUT), and average inflation targeting (AIT) rule. For all these three rules,

we distinguish between cases with zero weight on the unemployment gap and a positive weight

on the unemployment gap. We then compute responses to an inflationary supply shock, and

compare the performance in terms of inflation and employment stabilisation, and in terms of

cross-country and cross-household heterogeneity within the monetary union.

Our paper relates to the literature that assesses the performance of alternative Taylor rules.

For a survey see Taylor and Williams (2010). It also relates to the literature about the interaction

of monetary policy and labour market frictions as in the seminal work by Cooley and Quadrini

(1999) and Faia (2009), among others.

In terms of the focus on monetary policy rules, the

paper close to ours is Bundick and Petrosky-Nadeau (2021), who investigate possible effects of

ECB Working Paper Series No 2769 / January 20235changing from an interest rate rule that includes a response to deviations of unemployment from

its steady state value to one that stabilizes shortfalls. Feiveson et al. (2020) also investigate

monetary policy strategies, but focus on household heterogeneity. Our paper is related, but

distinct from both, as we use a multi-country open economy model featuring a more detailed

labour market structure, and a monetary union setup. This allows us to focus more on cross-

country heterogeneity within a monetary union, while it still allows some analysis of monetary

policy implications for different households.2

Our main findings are as follows. First, if monetary policy responds to the unemployment

gap, then this tends to have more favourable effects on unemployment. It results in stronger un-

employment decrease after expansionary demand shocks and lower unemployment increase after

a contractionary supply shock. While this does lead to a faster and stronger increase in inflation,

it also results in a fast return of inflation to lower levels after a supply shock. Responding to

unemployment tends to lower inequality between and within countries of the euro area. Second,

if monetary policy ignores unemployment and responds only to inflation, this leads to larger

fluctuations of output and (un)employment. Moreover, these fluctuations increase divergence

between the euro area economies as well as within-economy divergence among households. The

effect on between-household consumption differences is, however, different for expansionary and

contractionary shocks. When the central bank does not respond to unemployment, the differ-

ence between consumption of different types of households goes in favour of the hand-to-mouth

(HtM) households after an expansionary demand shock, while after an inflationary supply shock

this difference goes in favour of richer Ricardian households.

This paper proceeds as follows. Section 2 presents the details of the model. Section 3 presents

the monetary policy rules. Section 4 presents the empirical stylised facts and the way we used

them to calibrate the model. Section 5 discusses the results from different shock scenarios and

Section 6 concludes.

2We cannot, however, investigate these issues using global solution methods and study detailed distributional
implications, either across households as in Feiveson et al. (2020) or in time-series sense as in Bundick and
Petrosky-Nadeau (2021).

ECB Working Paper Series No 2769 / January 202362 The model

2.1 Overview

We first describe the modelling framework that we enhance with the labour market. The core

model on which we build is the EAGLE model, which is a multi-country dynamic general

equilibrium model of the euro area within the world economy. The EAGLE model was developed

as an ESCB project by a team composed of staff from the Bank of Italy, the Bank of Portugal

and the ECB, see Gomes et al. (2010) and Gomes et al. (2012). The model shares the same

theoretical setup as the ECB New Area Wide model, (Christoffel et al., 2008) or the IMF Global

Economy Model, GEM (Laxton and Pesenti, 2003). It is a large scale micro-founded model of

a monetary union that consists of an open economy version of the New Keynesian paradigm.

Given the purpose of our analysis, the version used here includes a significantly expanded and

enhanced labour market block, which we describe in detail in Section 2.2.

In the model, the world economy consists of four blocs. Two blocs are members of a monetary

union, the euro area (EA). Thus, these two blocs (Home and the Rest of the euro area, REA) have

a common nominal exchange rate and a common nominal interest rate. Regarding the monetary

authority, the central bank sets the domestic short-term nominal interest rate according to a

Taylor-type rule, by reacting to consumer price inflation, and unemployment gap, both defined

at the euro area level. In the simulations we use alternative monetary policy rules for the euro

area that are described in Section 3. The remaining two blocs, the US and the rest of the

world (RW), have their own nominal interest rates and nominal exchange rates. The monetary

authorities in theses blocs set the domestic short-term nominal interest rate according to a

Taylor-type rule that reacts to domestic variables (inflation and output growth). In all blocs,

fiscal policy is conducted at the country level. All regions trade with each other at the levels of

intermediate goods, with a matrix of bilateral trade flows based on recent historical averages.

International asset trade is limited to non-contingent nominal bonds denominated in US dollars.

In each country there are two types of firms. One type produces final non-tradable goods

under perfect competition using domestic tradable goods, imported tradable goods and non-

tradable goods. Final goods can be used for private consumption and for private investment.

There is also a final public good that is fully biased towards domestic non-tradable intermediate

goods. The other type of firms produces intermediate goods, which are produced by an array

of firms under monopolistic competition using domestic labour and capital, combined according

ECB Working Paper Series No 2769 / January 20237to a Cobb–Douglas technology. A set of intermediate goods firms produces tradable goods and

another set produces non-tradable goods. The market power implies that firms set nominal

prices and charge a markup over marginal costs. Nominal prices are sticky.

There are two types of infinitely-lived households in each country, Ricardian and non-

Ricardian (or HtM). Households gain utility from consuming and suffer disutility from working.

Ricardian households have access to financial markets, where they buy and sell domestic gov-

ernment bonds and internationally traded bonds denominated in US dollars (as well as an euro

denominated bond traded within euro area blocs), accumulate physical capital, rent their services

to firms, supply labour and hold money for transactions purposes. Non-Ricardian households

have only access to money balances, which means that their ability to intertemporally smooth

consumption is limited.

2.2 Labour market

We construct an enhanced labour market structure that we build onto the EAGLE model de-

scribed above. The labour market features search frictions as in Mortensen and Pissarides

(1999), but adds sticky wages by means of staggered wage setting, and a potential to distinguish

wage stickiness of new hires and existing workers. This approach follows broadly Bodart et al.

(2006) and de Walque et al. (2009). In addition, we distinguish between labour market segments

for Ricardian and non-Ricardian households, each of which can have their own unemployment,

hours worked, wage setting, and different wage rigidities for new hires and existing workers.

The aim of this relatively complex structure is to capture the labour market more realistically

in an otherwise two-agent model, in particular the facts that it is likely that wages for new hires

are more volatile than wages for existing workers (see e.g. Haefke et al. (2013) and Lydon and

Lozej (2018)) and that it is likely that poorer households are often those for whom employment

outcomes are more susceptible to business cycle fluctuations than for richer households. This

is in line with the evidence for several countries (see Cair´o and Cajner (2018) for the US, and

Broer et al. (2022) for Germany).

More volatile employment outcomes for a particular segment of wealth distribution are not

important in a representative-agent framework, where income fluctuations can be smoothed by

risk sharing among the households. However, as outlined in the above papers, labour market

at the bottom of the income distribution is different than at the top. This is why we need

this relatively complex setup of the labour market to be able to capture the more volatile

ECB Working Paper Series No 2769 / January 20238properties of the labour market at the bottom of the income distribution, i.e., the labour market

for non-Ricardian households. This has broader implications, because the fluctuations in this

labour market, due to the inability to smooth consumption, affect aggregate consumption and

aggregate fluctuations.

There are two labour market segments, one for Ricardian and one for non-Ricardian house-

holds. There is a continuum of labour firms in each labour market segment, with each labour firm

employing one worker. Labour firms pay labour taxes, bargain with households over wages, and

post vacancies at a per-period fixed cost. If they find a worker, they sell homogeneous labour

services to a labour packer, which aggregates labour from the Ricardian and non-Ricardian

labour market segments and sells aggregated labour services to intermediate goods firms.

The flows on the labour market are as follows. The number of workers in segment s (s = i

for Ricardian and s = j for non-Ricardian households) that are employed after the matching

process has been completed, ndes,t, evolves as follows:

ndes,t = (1 − δx) ndes,t−1 + Ms,t,

(1)

where Ms,t is the number of new matches formed in a period (with Ms,t > 0), and δx is the

fraction of existing employment relationships that have (exogenously) separated in each period

(i.e.

it is the exogenous separation rate, 0 < δx < 1). The number of matches Ms,t is defined

according to the following matching function:

Ms,t = ϕs,M (uns,t)µs(vacs,t)1−µs = pW

s,tuns,t = pF

s,tvacs,t,

(2)

where ϕs,M is matching efficiency, uns,t is the number of searching workers in each segment,
vacs,t is the number of vacancies, pW

s,t is the matching probability for workers of each type, pF

s,t is

the matching probability for firms, and µs, with (0 < µs < 1), is the elasticity of the matching

function with respect to unemployment in each segment.

The probability for a searching worker to find a job is

pW
s,t =

Mt
uns,t

= ϕs,M (

vacs,t
uns,t

)1−µs

(3)

and the probability of a firm finding a worker is

ECB Working Paper Series No 2769 / January 20239pF
s,t =

Ms,t
vacs,t

= ϕs,M (

vacs,t
uns,t

)−µs

(4)

The number of unemployed workers who search for work at the beginning of period t (i.e., the

number of workers who enter the matching process, uns,t) is equal to those who were unemployed

at the end of period t − 1 after the t − 1 matching has been completed (i.e., unes,t−1), plus the

newly separated workers (i.e., δxndes,t−1):

uns,t = unes,t−1 + δxndes,t−1,

(5)

These workers are the ones who receive unemployment benefits. The population of each bloc

in the model is standardised to 1, and so is the mass of households in each segment, so that

the number of unemployed at the end of the period in a segment s is unes,t = 1 − ndes,t. Total

unemployment in a bloc is a weighted unemployment across labour market segments, where ω

is the share of non-Ricardian households: unet = ω unej,t + (1 − ω)unei,t.

2.2.1 Value functions

We will require two sets of value functions. One set of value functions is for wages that have

been renegotiated in the current period, and one set of values for wages that have not been

renegotiated. We assume that wages that have not been renegotiated are indexed to inflation.

The notation follows closely the notation used in Bodart et al. (2006) and de Walque et al.

(2009).

Value functions for a labour firm Let AF (w∗

s,t) denote the value of a job for a firm employ-

ing a worker from household type s ∈ [i, j], where w∗

s,j is the renegotiated wage, and i stands

for a Ricardian and j for a non-Ricardian household. Following Bodart et al. (2006), it will be

convenient to use this value in marginal utility terms, so we define AF (w∗

s,t),
where u′(cs,t) is the marginal utility of consumption of household s. The value of a job with a

s,t) ≡ u′(cs,t)AF (w∗

renegotiated wage for a labour firm can then be written as

AF

t (w∗

s,t) = u′(cs,t)

(cid:16)

hαH
s,t xs,t − hs,tw∗

s,t(1 + τ wf

t

(cid:17)
)

+ β(1 − δx,s) (cid:2)(1 − ξw)AF

t+1(w∗

s,t+1) + ξwAF

t+1(w∗

s,t)(cid:3)

(6)

ECB Working Paper Series No 2769 / January 202310Here the term hαH

s,t denotes the effective hours that a labour firm produces from hours hs,t
supplied by the worker from household s.3 xs,t is what the labour packer pays for such unit

of labour. The first term in equation 6 therefore measures earnings of the labour firm from

selling hours worked. But for these hours it has to pay to the household hourly wage, which

is in this case newly renegotiated, w∗

s,t. Because we assume that labour firms pay some labour

taxes (social security contributions), the cost for the labour firm is increased by taxes paid, at
the rate τ wf

. In the next period, if the firm and the worker do not separate, which occurs with

t

probability (1 − δx,s), two cases can arise. In the first case, which occurs with the probability

(1−ξw), wages are renegotiated and the value of the worker for the labour firm is again the value

of a worker with a renegotiated wage, just in the next period, AF

t+1(w∗

s,t+1). With probability

ξw wages are not renegotiated and the firm is in next period stuck with the worker value at the

current wage, AF

t+1(w∗

s,t).

The value at t + 1 of the worker with renegotiated wage from time t is

AF

t+1(w∗

s,t) = u′(cs,t+1)

hαH
s,t+1xs,t+1 − hs,t+1w∗
s,t

(cid:18)

+ β(1 − δx,s) (cid:2)(1 − ξw)AF

t+2(w∗

(1 + π)Pt
Pt+1
s,t+2) + ξwAF

t+2(w∗

s,t)(cid:3)

(cid:19)

(1 + τ wf

t+1)

(7)

The wage from the previous period has been indexed by the ratio of trend inflation π and the

price level growth, Pt/Pt+1 = (1 + πt+1).4

If we substitute equation 7 into equation 6, and do this for every future period, we arrive at

the following expression:

AF

t (w∗

s,t) =

∞
(cid:88)

k=0

[β(1 − δx,s)ξw]k u′(cs,t+k)hαH

s,t+kxs,t+k

∞
(cid:88)

k=0

[β(1 − δx,s)ξw]k u′(cs,t+k)

(1 + π)kPt
Pt+k

hs,t+k(1 + τ wf
t+k)

(8)

β(1 − δx,s)(1 − ξw) [β(1 − δx,s)ξw]k AF

t+k+1(w∗

s,t+k+1)

− w∗
s,t

+

∞
(cid:88)

k=0

3Note that αH is very close to 1.
4Indexation can be with respect to trend inflation or any other inflation rate that has the same trend growth
as trend inflation. In the simulations we will assume that indexation is with respect to current inflation. The
reason is that if nominal wages are indexed to trend inflation, real average wages fall when current inflation rises,
even when newly negotiated wages rise. This makes only minor differences for the outcomes of our simulations,
but would unnecessarily complicate the explanation.

ECB Working Paper Series No 2769 / January 202311As in Bodart et al. (2006), we can define auxiliary variables and write the infinite sums in

recursive form. For the first line in equation 8, define

Sx

t ≡

∞
(cid:88)

k=0

[β(1 − δx,s)ξw]k u′(cs,t+k)hαH

s,t+kxs,t+k = u′(cs,t)hαH

s,t xs,t + β(1 − δx,s)ξwSx

t+1

Similarly, for the second line, define

Sw

t ≡

∞
(cid:88)

k=0

[β(1 − δx,s)ξw]k u′(cs,t+k)hs,t

(1 + π)kPt
Pt+k

(1 + τ wf

t

)

= u′(cs,t)hs,t(1 + τ wf

t

) + β(1 − δx,s)

(1 + π)
(1 + πt+1)

ξwSw

t+1

Using these definitions, we can simplify equation 8 to

AF

t (w∗

s,t) = (cid:0)Sx

t − Sw

t w∗
s,t

(cid:1) +

∞
(cid:88)

k=0

β(1 − δx,s)(1 − ξw) [β(1 − δx,s)ξw]k AF

t+k+1(w∗

s,t+k+1)

(9)

(10)

(11)

= (cid:0)Sx

t − Sw

t w∗
s,t

(cid:1) − β(1 − δx,s)ξw

(cid:0)Sx

t+1 − Sw

t+1w∗

s,t+1

(cid:1) + β(1 − δx,s)AF

t+1(w∗

s,t+1)

To get rid of the infinite sum in the first line of equation 11 we used the fact that AF

t (w∗

s,t) can

be multiplied by β(1 − δx,s)ξw, forwarded by one period, and the result subtracted from both

sides of the first line. After rearranging, we obtain the second line.

We can then similarly define the value of a worker with an average wage for a labour firm:

AF

t (ws,t) = u′(cs,t)

(cid:16)

s,t xs,t − hs,tws,t(1 + τ wf
hαH

t

(cid:17)
)

+ β(1 − δx,s) (cid:2)(1 − ξw)AF

t+1(w∗

s,t+1) + ξwAF

t+1(ws,t)(cid:3)

(12)

Following the same steps as above, we obtain, after some algebra

AF

t (ws,t) = (Sx

t − Sw

t ws,t) − β(1 − δx,s)ξw

(cid:0)Sx

t+1 − Sw

t+1ws,t+1

(cid:1) + β(1 − δx,s)AF

t+1(ws,t+1) (13)

ECB Working Paper Series No 2769 / January 202312Free entry condition A firm posting a vacancy for household type s must pay a per-period

constant cost ψs for having a vacancy open. If κws denotes the probability that a firm cannot

renegotiate the wage for a newly hired worker from household type s, then the value of employing

a new worker is, in monetary terms (recall, AF (w∗

s,t) ≡ u′(cs,t)AF (w∗

s,t), and the same for the

value at average wage), equal to the weighted average of the value of a worker at a newly-

renegotiated job and the value of a worker hired at average wage. The free-entry condition is

therefore:

ψs = pF

t β

u′(cs,t+1)
u′(cs,t)

(cid:2)(1 − κws)AF

t (w∗

s,t+1) + κwsAF

t (ws,t+1)(cid:3) .

(14)

Value functions for a worker Similarly as for labour firms, we can define value functions

for workers. Again we have two types of value functions, one for a newly-renegotiated wage and

one for the average wage, for each type of household. The value of a job, net of the value of

unemployment, for a worker with newly-renegotiated wage is

AH

t (w∗

s,t) = u′(cs,t)

(cid:16)

hs,tws,t(1 − τ wh

t

) − bs,t

(cid:17)

− χ

h1+φ
s,t
1 + φ
s,t+1) + ξwAH

+ β(1 − δx,s) (cid:2)(1 − ξw)AH
(cid:2)(1 − κws)AH

− βpW
s,t

t+1(w∗

t+1(w∗

s,t+1) + κwsAH

s,t)(cid:3)
t+1(w∗
t+1(ws,t+1)(cid:3)

(15)

The first line of equation 15 denotes, in utility terms, first the net gain of having a job,

which is hours worked times wage net of taxes paid by the household, at a rate τ wh

t

and net of

opportunity cost of having a job, which are unemployment benefits, bs,t.5 The second term in
the first line is the disutility of hours worked.6 The second line represents the value of having

a job in the next period, which occurs with the probability (1 − δx,s). This job can be either

at the newly renegotiated wage or at the current wage. The last row of equation 15 is the

value of the opportunity cost of having a job, which is the value of being unemployed.

If a

worker is unemployed, then there is a probability pW

s,t to find a job, which can be either at a

newly-renegotiated wage with probability (1 − κws), or at an average wage, with probability κws.

5We assume that unemployment benefits are a fraction (replacement ratio) of average wage and are indexed

in the same way as the average wage.

6We assume that the household as a whole sends its members to work, so that the marginal disutility for the

household is the disutility for the worker.

ECB Working Paper Series No 2769 / January 202313If we follow the same sequence of steps as we did for the firm and define an additional

auxiliary variable to sum the disutility of labour terms,

Sh

s,t = χ

h1+φ
s,t
1 + φ

+ β(1 − δx,s)ξwSh

s,t+1,

then we can write the net value of a job for a new wage for the household:

AH

t (w∗

s,t − bs,t)(cid:1) − β(1 − δx,s)ξw

(cid:0)Sw

t+1w∗

s,t+1 − bs,t+1

(cid:1)

t (w∗

s,t) = (cid:0)Sw
s,t + β(1 − δx,s)ξwSh
− Sh
+ β (cid:2)1 − δx,s − (1 − κws)pW

s,t+1

(cid:3) AH

t+1(w∗

s,t+1) − βκwspW

s,tAH

t+1(ws,t+1)

s,t

(16)

(17)

In a similar fashion, we can obtain the value of a job for an average wage for the household:

AH

t (ws,t) = Sw

t (ws,t − bs,t) − β(1 − δx,s)ξw

(cid:0)Sw

t+1ws,t+1 − bs,t+1

(cid:1)

s,t+1

s,t + β(1 − δx,s)ξwSh

− Sh
+ β (cid:2)(1 − δx,s)(1 − ξw) − (1 − κws)pW
+ β (cid:2)(1 − δx,s)ξw − κwspW

(cid:3) AH

s,t

s,t

t+1(ws,t+1)

(cid:3) AH

t+1(w∗

s,t+1)

(18)

2.2.2 Wages and hours

We assume that wages and hours are determined using Nash bargaining. Assuming standard

(efficient) Nash bargaining between households and labour firms, every period, wages and hours

worked are determined by maximising the following expression, where 0 < ηs < 1 measures the

bargaining power of workers of type s:

max
s,t,hs,t

w∗

(cid:0)AH

t (w∗

s,t)(cid:1)ηs (cid:0)AF

t (w∗

s,t)(cid:1)1−ηs .

The result is that wages are split according to the Nash sharing rule:

ηs(1 − τ wh

t

)AF

t (w∗

s,t) = (1 − ηs)(1 + τ wf

t

)AH

t (w∗

s,t).

(19)

(20)

The intuition for the above rule is that households and labour firms bargain over each other’s

matching surpluses, where the surplus of the firm is the value of the worker (because in equilib-

ECB Working Paper Series No 2769 / January 202314rium the value of the vacancy is zero), and for the household the value of the match is the net gain

from being employed (relative to being unemployed), both evaluated at the currently-negotiated

wage. The above equation thus determines w∗

t,s.

The average wage is determined by using the law of motion of labour as follows:

ndes,ths,tws,t = (1 − δx,s)ndes,t−1

ws,t−1hs,t + (1 − ξw)w∗

s,ths,t

(cid:20)
ξw

1 + π
1 + πt−1
(cid:2)κwsws,ths,t + (1 − κws)w∗

s,ths,t

(cid:3) ,

+ Ms,t

(cid:21)

(21)

where the first row is the average wage of existing workers and the second row is the average

wage of new hires, with the number of new matches Ms,t counting the number of new hires.7

Similarly, hours worked are determined by per-period Nash bargaining, and after taking into

account the wage decision (equation 20), hours worked expression is:

αH xs,t(hs,t)αH−1 =

χ
u′(cs,t)

(1 + τ wf
(1 − τ wh

t

t

)
)

(hs,t)φ.

(22)

The term on the left is the marginal revenue from labour services brought about by an

additional hour worked and the term on the right is the marginal disutility of having to work

an additional hour, in after-tax consumption terms.

Note that throughout our notation we have assumed that hours worked do not depend on

wages. Equation (22) shows that under the assumption of efficient Nash bargaining, this is

indeed the case.8

2.2.3 Labour packer

Labour from Ricardian and non-Ricardian households is aggregated by a labour packer using a

CES technology, as follows:

1− 1
η
t

n

(cid:20)

=

(1 − ω)

(cid:16)

1
η

ndei,thαH
i,t

(cid:17)1− 1

η + ω

(cid:16)

1
η

ndej,thαH
j,t

(cid:17)1− 1
η

(cid:21)

,

(23)

where nt are aggregate labour services and ndes,thαH

s,t are total labour services provided by labour

7If indexation is with respect to current-period inflation, the ratio of inflation rates that multiplies the previous-

period wage drops out, because previous-period wage is indexed to previous-period inflation.

8There are other cases, which change the relation between hours and wages and open the so-called wage
channel, see Christoffel and Linzert (2010) and the application in Bodart et al. (2006) and de Walque et al.
(2009).

ECB Working Paper Series No 2769 / January 202315firms in household segment s. Parameter ω measures the share of non-Ricardian households in

the economy.

3 Monetary policy rules

We consider three different types of monetary policy rules in the euro area.

Benchmark Taylor rule

rt = φr rt−1 + (1 − φr) (r∗ + π∗ + φπ (πt − π∗) + φu ˆut) + ϵR
t

(24)

where rt is the annualised nominal interest rate, r∗ is the annualised long-run equilibrium real
interest rate, πt is the annual price inflation rate, π∗ is the annual inflation target, and ˆut is the

unemployment gap, i.e. the gap between the unemployment rate unet and its steady-state level,

une.9 ϵR
t

is a shock.

Taylor rule with an asymmetric response to unemployment

rt = φr rt−1 + (1 − φr) (r∗ + π∗ + φπ (πt − π∗) + Iu>u∗φU ˆut) + ϵR
t

(25)

where Iu>u∗φU is an indicator function that takes the value 1 if the unemployment rate is above

its steady-state value u∗ and 0 otherwise. This rule follows Board of Governors of the Federal

Reserve System (2022) and Bundick and Petrosky-Nadeau (2021).

Average inflation targeting rule

rt = φr rt−1 + (1 − φr) (cid:0)r∗ + π∗ + φπ

(cid:0)¯πT

t − π∗(cid:1) + φu ˆut

(cid:1) + ϵR
t

(26)

where ¯πT
t

is the annualised average inflation rate over the past T years (T is the averaging

window, which we set to be equal to 4 years).

9The monetary policy increases (decreases) interest rates when the unemployment rate is below (above) its

steady state value. For convenience purposes, the gap is defined such that the parameter φu is positive.

ECB Working Paper Series No 2769 / January 2023164 Calibration

This section describes the sources used for the calibration and the rationale for the choices that

were made when calibrating the model. We have made two major updates to the calibration of

the original EAGLE model. First, in line with the existing models of similar size (e.g., Bayoumi

et al. (2004), Faruqee et al. (2008)), we calibrate the great ratios and trade direction based on

national accounts, while keeping in line with the empirical estimates in Christoffel et al. (2008))

for the euro area. Second, we provide more detail on the calibration of the labour market in

the model, which is a novel feature of the model, with more focus on heterogeneity, both across

countries and between the agents within each country.

The values for the great ratios are reported in Table 1. The sample we use is from 1999-

2019, which covers the period from the start of the euro to the beginning of the COVID-19 crisis.

Compared to earlier calibrations (Gomes et al. (2010) and Gomes et al. (2012)) countries have

become more open, the share of public investment in Europe has declined, and the interest rate

has been lower. Table 2 reports the corresponding trade matrix.

Table 1. Steady-State National Accounts (Ratio to GDP, %)

Domestic demand
Private consumption
Private investment
Public consumption
Public investment
Trade
Imports (total)
Imports of consumption goods
Imports of investment goods
Net foreign assets (ratio to annual GDP)
Production
Tradables
Non-tradables
Labour
Share of world GDP

Home REA

US

RW

59.90
18.20
19.3
2.20

35.60
23.73
11.87
40

58.19
18.30
20.00
3.40

19.20
16.24
2.96
-15

62.50
17.20
16.00
3.80

15.20
9.63
5.57
-

61.30
20.00
16.00
3.00

16.39
9.46
6.93
40

39.00
61.00

35.16
65.14

34.59
65.41

37.52
62.48

5.4

13.8

25.5

55.3

Note: REA=Rest of the euro area; US=United States; RW=Rest of world

For nominal rigidities related to goods prices, we report the markups in Table 3. These

follow the estimates from Christoffel et al. (2008) and the calibration in Gomes et al. (2012).

Table 4 shows the calibration of the household and firm sectors. In line with the low real

interest rates observed in the sample period, we calibrate the household discount factor to

ECB Working Paper Series No 2769 / January 202317Table 2. International Linkages (Trade Matrix, Share of Domestic GDP, %)

Home REA US RW

23.73

16.24

9.63

9.46

-
11.25
1.48
10.99

2.46
-
0.38
13.40

0.41
1.03
-
8.18

1.17
3.89
4.40
-

11.87

2.96

5.57

6.93

Consumption-good imports
Total consumption good imports
From partner
Home
REA
US
RW
Investment-good imports
Total investment good imports
From partner
Home
REA
US
RW

0.80
2.41
3.72
-
Note: REA=Rest of the euro area; US=United States; RW=Rest of world

1.79
-
0.53
0.65

0.25
0.50
-
4.83

-
5.63
0.75
5.50

Table 3. Price Markups (Implied Elasticities of Substitution)

Home
REA
US
RW

Tradables (θT ) Non-tradables (θN )

1.20 (6.0)
1.20 (6.0)
1.20 (6.0)
1.20 (6.0)

1.50 (3.0)
1.50 (3.0)
1.28 (4.6)
1.28 (4.6)

Note: REA=Rest of the euro area; US=United States; RW=Rest of world

ECB Working Paper Series No 2769 / January 202318Table 4. Households, Entrepreneurs and Firms Behaviour

Home

REA

US

RW

4

1.01− 1
1.00
0.70
0.025
0.25

4

1.01− 1
1.00
0.70
0.025
0.25

4

1.01− 1
1.00
0.70
0.025
0.25

4

1.01− 1
1.00
0.70
0.025
0.25

Households
Discount factor (β)
Intertemporal elasticity of substitution (σ−1)
Habit persistence (κ)
Capital depreciation rate (δK)
Share of non-Ricardian households (ω)
Interm.-good firms (trad. and non-trad. sectors)
Subst. btw. labour and capital
Bias towards capital - tradables (αT )
Bias towards capital - non-tradables (αN )
Production - labour services (αH )
Final consumption-good firms
Subst. btw. domestic and imported trad. goods (µT C)
Bias towards domestic tradable goods (vT C)
Subst. btw. tradables and non-tradables (µC)
Bias towards tradable goods (vC)
Substitution btw. consumption good imports (µIM C)
Final investment-good firms
Subst. btw. domestic and imported trad. goods (µT I )
Bias towards domestic tradable goods (vT I )
Substitution btw. tradables and non-tradables (µI )
Bias towards tradable goods (vI )
Substitution btw. investment good imports (µIM I )

0.60
0.76
0.50
0.75
0.60
Note: REA=Rest of euro area; US=United States; RW=Rest of world

0.60
0.40
0.50
0.75
0.60

1.00
0.30
0.30
0.99

0.60
0.28
0.50
0.45
0.60

1.00
0.30
0.30
0.99

0.60
0.22
0.50
0.45
0.60

1.00
0.30
0.30
0.99

0.60
0.65
0.50
0.35
0.60

0.60
0.71
0.50
0.75
0.60

1.00
0.30
0.30
0.99

0.60
0.59
0.50
0.35
0.60

0.60
0.56
0.50
0.75
0.60

ECB Working Paper Series No 2769 / January 202319correspond to 1% real interest rate per annum.

The details of the labour market calibration are reported in Table 5. The labour supply

elasticity is set to 0.2 (its inverse, ζ = 5) and is lower than typically in the literature (0.5, or

its inverse ζ = 2) to mitigate the response of hours worked, in line with empirical evidence that

hours per worker (intensive margin) are relatively stable compared to unemployment (extensive

margin).10 Matching probabilities of Ricardian and non-Ricardian workers come from own esti-

mates, computed using the OECD and Eurostat data for unemployment duration by educational

attainment for 2017 and 2018 using the method of Shimer (2012), where we assume that non-

Ricardian households are those with below upper-secondary education and Ricardians are those

above upper secondary education.11 The matching probability for firms in both segments is

based on the estimates for the US in Ramey et al. (2000) (similar values are used in St¨ahler and

Thomas (2012)). Unemployment rates are averages from 2004-2019, based on OECD data. As

for job finding rates, we assume that the unemployment rate for non-Ricardian households is the

unemployment rate for persons with educational attainment below upper-secondary. Matching

efficiency and vacancy posting costs are calibrated to fit matching probabilities. The outcomes

are roughly in line with the literature (for instance, Jung and Kuhn (2014) find that the match-

ing efficiency in Germany is low compared to the US, which also comes out of our calibration).

We calibrate the break-up rate of non-Ricardians to match the level of unemployment in this

group in each bloc, while we use the break-up rate of Ricardians to match the overall rate of

unemployment. Because the unemployment rate of non-Ricardians is larger, this also results in

larger break-up rate for this group of households across blocs. Bargaining power has been set to

0.5, for both groups of households, in line with the literature. We calibrate the matching elastic-

ity for Ricardian households to 0.5, which is in the middle of the range reported by Petrongolo

and Pissarides (2001). For the non-Ricardian households, we set this elasticity to a lower value

of 0.2, to prevent that a cyclical increase in unemployment of non-Ricardians would generate

numerous new matches. Unemployment benefits are set as a proportion of the steady-state

wage (the replacement ratio). Replacement ratios are based on the OECD estimates. We use

one-year horizon for Ricardian households and two-year horizon for non-Ricardian households,

10Recall that the model has an intensive and extensive margin, so that aggregate hours worked do fluctuate

more than individual hours worked.

11The estimates are population-weighted across countries. Because we only have data for OECD countries
(and not all of them), we made the following approximations. The REA is based on Austria, Belgium, Estonia,
Finland, France, Greece, Italy, Latvia, The Netherlands, Slovakia, Slovenia, and Spain. The RW is based on
Czechia, Denmark, Hungary, Norway, Sweden and Poland.

ECB Working Paper Series No 2769 / January 202320reflecting the fact that the latter are more likely to be long-term unemployed, to determine the

replacement ratios. Finally, probabilities to renegotiate an existing wage and the probabilities

to start the new job at the average wage were taken from de Walque et al. (2009). Because we

have no evidence that these rates differ between Ricardian and non-Ricardian households, we

kept them the same across both groups.

Table 5. Labour market

Inverse of the Frisch elasticity of labour supply (ζ)
Matching probability, Ricardian workers, (pW
i )
Matching probability, HtM workers, (pW
j )
Matching probability, firms, (pF
s )
Matching efficiency, Ric. w., (φi,M )
Matching efficiency, HtM w. ,(φj,M )
Vac. posting cost, Ric. w.,(Ψi)
Vac. posting cost, HtM w., (Ψj)
Break-up rate, Ric. w., (δxi)
Break-up rate, HtM w., (δxj)
Disutility of labour, Ric. w., (χi)
Disutility of labour, HtM w., (χj)
Matching elasticity, Ric. w., (µi)
Matching elasticity, HtM w., (µj)
Bargaining power, Ric. w., (η)
Bargaining power, HtM w., (η)
Replacement ratio, Ric. w., (rrati)
Replacement ratio, HtM w., (rratj)
Unemployment rate, (un)
Unemployment rate, HtM w., (unj)
Prob. to renegotiate existing wage, Ric. w., (ξwi)
Prob. to renegotiate existing wage, HtM w., (ξwj)
Prob. to start job at avg. wage, Ric. w., (κwi)
Prob. to start job at avg. wage, HtM w., (κwj)

Home
5.00
0.3021
0.2090
0.70
0.4598
0.5496
0.4091
1.2933
0.0203
0.0443
1.1481
4.6902
0.50
0.20
0.50
0.50
0.590
0.228
0.0696
0.1437
0.8879
0.8879
0.7
0.7

REA
5.00
0.2238
0.1848
0.70
0.3957
0.5363
0.6768
1.0133
0.0298
0.0348
1.2333
4.2066
0.50
0.20
0.50
0.50
0.590
0.486
0.1038
0.1334
0.8879
0.8879
0.7
0.7

US
5.00
0.5292
0.5385
0.70
0.6086
0.6642
1.1325
0.8246
0.0592
0.1179
1.3882
4.8728
0.50
0.20
0.50
0.50
0.084
0.084
0.0605
0.0918
0.8879
0.8879
0.7
0.7

RW
5.00
0.3442
0.2598
0.70
0.4908
0.5741
0.9170
1.1525
0.0344
0.0359
1.4416
4.4392
0.50
0.20
0.50
0.50
0.386
0.320
0.0694
0.0930
0.8879
0.8879
0.7
0.7

Note: REA=Rest of the euro area; US=United States; RW=Rest of world

We parametrise the euro area monetary policy rules as shown in Table 6. The parameters

are in line with Gomes et al. (2010) and Gomes et al. (2012).12 The new parameters φu and

φI that determine the weight on unemployment and asymmetric reaction to are set in line with

Rudebusch (2010) and Elias et al. (2014). We consider several weights for the response of the

central bank to unemployment.

12We keep the monetary policy rule in the RW and in the US at the standard Taylor rule form, where the
central bank responds to inflation and the output growth, with the interest rate inertia set to 0.87, the response
to the deviation from the annual inflation target at 1.70, and the response to the output growth at 0.10.

ECB Working Paper Series No 2769 / January 202321Table 6. Monetary policy rules

Interest rate smoothing, φr
Response to inflation, φπ
Response to unemployment, φu
Inflation target, π∗
Real rate, r∗

Euro area
0.87
1.70
(0.00, 2.00, 3.00)
2.00
1.00

5 Scenarios

We compute the responses of a number of variables to an expansionary (inflationary) aggregate

demand shock across the euro area. This is a type of shock that pushes inflation and real activity

in the same direction and therefore a shock where a central bank can counter an increase in

inflation likely without causing a recession. Next, we consider an inflationary aggregate supply

shock, which is contractionary for real activity (and employment), and therefore leads to a

trade-off between stabilising prices and worsening economic activity.

These shocks provide us the framework to analyse and compare the performance of different

monetary policy rules (benchmark Taylor rule with IT, ASUT, AIT) for a stylised set of circum-

stances encountered by policymakers. The three rules by design already differ in terms of how

actively the central bank responds to an increase in inflation. In addition, for each rule, we also

distinguish between cases with zero weight on the unemployment gap and with positive weight

on unemployment gap (defined as the difference between steady state unemployment and actual

unemployment), where the policy rate falls if unemployment increases.

5.1 Expansionary demand shock

For the expansionary demand shock we consider a combination of a preference shock and an

investment technology shock, symmetrically in both regions that constitute the euro area.13 The

reason for opting for a combination of shocks is that we wanted to mimic a broad increase in

consumption and investment demand, rather than a shift between consumption and investment,

which is what only one of the two structural shocks would generate. The shock sizes are stan-

dardised to achieve a 1 p.p. maximum increase in inflation (annualised) under the benchmark

rule (IT) with a positive weight on unemployment, and this size of the shocks is kept fixed across

simulations with different monetary policy rules.

13Shocks are persistent with the quarterly AR(1) coefficient of 0.9.

ECB Working Paper Series No 2769 / January 202322Figures 1 and 2 show the euro-area-wide variables for the three interest rate rules, one in

each column and for different weights placed on unemployment. The full black line shows the

case when the central bank responds to the unemployment rate and the dashed red line shows

the case where the central bank does not respond to unemployment. For the ASUT rule the case

where the weight on unemployment is zero always corresponds to the strict inflation targeting

rule, i.e., to dashed red lines in the leftmost column of the figure.

Three observations stand out. First, not reacting to unemployment tends to exacerbate

fluctuations in all variables (except the nominal interest rate), under all rules. This is expected,

because placing some weight on unemployment implies that the central bank tightening in an

economic expansion should be stronger if unemployment decreases in addition to an inflation

increase. When monetary authority responds to unemployment, it counteracts the decline in

unemployment, the expansion of economic activity is smaller and the increase in inflation is

also milder. Note that in the case of the ASUT, given that the shock implies a decrease in

unemployment, the rule’s response to the unemployment rate is not triggered, so the rule boils

down to a “pure” IT rule (i.e. a rule that only responds to inflation developments). This implies

that a stronger response to unemployment (which we show with dotted red line) coincides with

the less aggressive reaction to unemployment and both coincide with strict inflation targeting.

In the case of a negative (i.e. deflationary) demand shock the opposite happens, the response

to unemployment is triggered and the responses would basically correspond to the benchmark

case or be more inflationary with lower employment losses in case of the more aggressive rule

(see Appendix A).

Second, fluctuations tend to be more pronounced under the AIT rule, even when the rule

does include a response to unemployment. The reason is that the AIT rule is relatively slow to

react, so interest rates rise more slowly in response to an economic expansion, which delays the

dampening of demand. This can be seen in a slower and weaker increase in nominal rates and

a stronger decrease in real interest rates under the AIT compared to other rules. Including the

response to unemployment in the AIT rule helps dampening the fluctuations, because unem-

ployment has a non-zero weight in the rule and an unemployment decrease implies that under

the AIT the central bank can respond less sluggishly (see the bottom-right panel of Figure 2).

Figures 3 to 5 show country-specific outcomes in the euro area for the three monetary policy

rules. The Home country is shown with red lines and the rest of the euro area with black

lines. The first thing to note are considerable differences between the two regions regardless of

ECB Working Paper Series No 2769 / January 202323Figure 1. Expansionary demand shock: area-wide demand components

Horizontal axes: quarters; vertical axes: percent deviations from the steady state. All variables are in real terms.

0102030024OutputWith IT0102030024With ASUT0102030024With AIT0102030024Consumption0102030024010203002401020300510Investment01020300510010203005100102030-4-202Export0102030-4-2020102030-5050102030024Import01020300240102030024With u=2With u=0ASUT with u=3ECB Working Paper Series No 2769 / January 202324Figure 2. Expansionary demand shock: area-wide variables

Horizontal axes: quarters; vertical axes: percentage point deviations from the steady state, except wages, which
are in precent deviations. Interest rates and inflation are annualised.

010203000.20.40.6Average wagesWith IT010203000.20.40.6With ASUT010203000.51With AIT0102030-1-0.50Unemployment0102030-1-0.500102030-1-0.500102030012Inflation010203001201020300120102030-2-101Real rate0102030-2-1010102030-2-101010203000.511.5Nominal rate010203000.511.5010203000.51With u=2With u=0ASUT with u=3ECB Working Paper Series No 2769 / January 202325the monetary policy rule. This reflects in part the differences in the labour markets, but also

differences in the structure of the economy. One such difference between the EA blocs is in terms

of import-content of investment, where Home imports a much bigger share of investment goods

than the REA. This is part of the reason why imports in Home increase as much as in the REA

even though investment and consumption increase by less. Another reason for the differences is

the export orientation of the two euro-area blocs. Home is much more open to outside-euro-area

blocs, i.e., the RW and the US, while the REA is more closed. This leads to a different degree of

exposure to the euro exchange rate and therefore different fluctuations in exports, as can clearly

be seen in Figure 3. The REA finances its increase in consumption and investment by running

a large trade deficit, while Home runs a lower trade deficit because it finances it by an increase

in exports.

Differences in labour market structure also lead to some divergence between countries. For

instance, while Home’s output increases by about a two thirds as much as the REA output,

unemployment drops by half as much as in the REA. The reason for this more sluggish response

of unemployment is that wages in Home increase by about half as much as in the REA, but

more persistently, which dampens hiring.

Figure 5 explains where among the households this dampening of hiring occurs. In Home,

most of the dampening of hiring is among the poor HtM households. There, the job finding

probability increases the least, compared with the Ricardian households. This is not the case

in the REA, where most of the adjustment in employment and job finding is on the side of the

poor HtM households. This holds throughout the rules and regardless of whether the central

bank attaches some weight to unemployment or not.

Interestingly, if the central bank does not react to unemployment after an expansionary

shock, this implies that consumption level of the poor households in both EA regions increases

by more than the consumption level of richer Ricardian households and therefore leads to a

reduction in consumption inequality. Here it is appropriate to recall part the statement of

Chairman Powell (2020) that we cited in the Introduction, namely the “... appreciation of

a strong labour market, particularly for many in low- and moderate-income communities ...”.

In the case of an expansionary demand shock, this line of thinking implies that central banks

seeking to reduce inequality in consumption should allow for somewhat higher inflation by not

tightening in response to a strong labour market. This is akin to the asymmetric unemployment

targeting rule, which would ignore unemployment whenever it decreased below its steady-state

ECB Working Paper Series No 2769 / January 202326value (or respond less to its decrease), as displayed in the middle panel of the figure, where the

full and dotted lines coincide.14

Another important takeaway from the cross-country comparison is that the divergence be-

tween two intra-EA regions tends to be the strongest when fluctuations are large in absolute

terms, which happens when monetary policy does not respond to unemployment. Similarly,

the divergence in consumption levels of households within each country also tends to be higher

when the central bank does not respond to unemployment (that is, the inequality in consump-

tion in the REA is reduced more strongly than in Home when central bank does not react to

unemployment).

5.2

Inflationary supply shock

We now investigate the performance of monetary policy rules under the shock scenario that

induces a trade-off between stabilizing inflation and unemployment. To achieve this, we simulate

an asymmetric and equal increase in markups in tradable and non-tradable sectors in both blocs

of the euro area.15 As before, the size of the shock is calibrated to achieve a 1 p.p. maximum

increase in the euro-area-wide inflation under the benchmark ¡rule and the size of the shock is

kept the same across policy rules.

Figures 6 and 7 show the euro area-wide outcomes. The supply shock generates an increase

in inflation and a negative impact on economic activity. Also in this case the fluctuations in

(un)employment, aggregate demand and its components are stronger if the central bank pays

no attention to unemployment, while in this case inflation shows a much milder increase.

Compared to the other two rules, AIT tends to attenuate or even neutralise the negative real

impact of the shock in the first few quarters when the central bank reacts to unemployment,

mainly because this rule stipulates a slower increase in the nominal rate, which results in a

stronger drop in real interest rate and hence an increase in Ricardian households’ consumption

in the short run. Recall that these households represent 75% of all households and that their

consumption level is about a quarter higher than consumption of HtM households, so that

Ricardian households have a strong influence on aggregate consumption. This effect on Ricardian

households’ consumption due to a lower real rate is present for all rules and can also be observed

for the more aggressive ASUT rule in the middle column. Moreover, in the case of the AIT rule

14We are grateful to Jelena Zivanovic for alerting us to asymmetric unemployment targeting.
15Shocks are persistent with the quarterly AR(1) coefficient of 0.9.

ECB Working Paper Series No 2769 / January 202327Figure 3. Expansionary demand shock: country-specific demand components

Horizontal axes: quarters; vertical axes: percent deviations from the steady state. All variables are in real terms.

0102030024OutputWith IT0102030024With ASUT0102030024With AIT0102030024Consumption0102030024010203002401020300510Investment01020300510010203005100102030-4-202Export0102030-4-2020102030-5050102030024Import01020300240102030024REA, u=2REA, u=0REA, ASUT, u=3Home, u=2Home, u=0Home, ASUT, u=3ECB Working Paper Series No 2769 / January 202328Figure 4. Expansionary demand shock: country-specific variables

Horizontal axes: quarters; vertical axes: percent deviations from the steady state. All variables are in real terms.

010203000.51Avg. wages - Ricard.With IT010203000.51With ASUT010203000.51With AIT010203000.51Avg. wages - HtM010203000.51010203000.510102030-1-0.50Unempl. - Ricard.0102030-1-0.500102030-1-0.500102030-2-10Unempl. - HtM0102030-2-100102030-2-10010203000.511.5Real eff. exchange rate010203000.511.50102030012REA, u=2REA, u=0REA, ASUT, u=3Home, u=2Home, u=0Home, ASUT, u=3ECB Working Paper Series No 2769 / January 202329Figure 5. Expansionary demand shock: country-specific variables

Horizontal axes: quarters; vertical axes: percent deviations from the steady state, except job finding rates and
relative consumption, which are in p.p. deviations. All variables are in real terms.

0102030024Consumption - HtMWith IT01020300246With ASUT0102030024With AIT0102030024Consumption - Ricardian0102030024010203002401020300510Job f. p. - HtM010203005100102030051001020300246Job f. p. - Ric.01020300246010203002460102030-1012C of HtM/C of Ric.01020300120102030012REA, u=2REA, u=0REA, ASUT, u=3Home, u=2Home, u=0Home, ASUT, u=3ECB Working Paper Series No 2769 / January 202330this effect is sufficiently strong that it prevents the short-run increase in unemployment, which

shields the income and consumption of HtM households in the short run (these effects can most

clearly be seen by looking at full lines in Figure 10).

Unlike for the expansionary demand shock, the supply shock generates an increase in unem-

ployment and therefore triggers a monetary policy response. For instance, the ASUT rule in its

more aggressive version achieves a lower peak increase in unemployment than AIT that responds

to unemployment. Therefore, the ASUT rule mitigates the effect of the shock on unemployment

but at the cost of higher inflation.

Figures 8 to 10 show the responses across countries, members of the euro area. Home is

shown in black and the REA in red lines. Compared to the expansionary demand shock, the

responses of both EA blocs to the shock are less divergent. The main reason for this is that

production functions of Home and the REA do not differ as much as their structures of aggregate

demand. Nevertheless, we still see some common properties of the monetary policy rules. First,

we again observe a much stronger divergence between Home and the REA when monetary policy

only responds to inflation (impulse responses shown with dashed lines tend to be more apart

than impulse responses shown with full lines, with the exception of wages and consumption of

HtM households). This holds across all three types of rules (IT, ASUT, AIT).

Second, we can see how the effect of lower real rate stimulates consumption of Ricardian

households in the short run when central bank reacts to unemployment in Figure 10. Across

the rules, but especially for ASUT and AIT, this temporary increase in aggregate demand in-

creases job finding probability of HtM households, which for a short period of time protects

their employment, income and consumption. The reason why there is an increase in job finding

probability for HtM households is that their wages decrease by more than wages of Ricardian

households, which shifts aggregate labour demand from firms more towards the now cheaper

labour of HtM households. In this case we also observe that the divergence between Ricardian

and HtM households’ consumption is limited. This is in stark contrast with the case where cen-

tral bank only responds to inflation and where employment, wages, and job finding probabilities

fall across the board already on impact. In this case, we also see a strong increase in inequality

in terms of consumption in both EA blocs, as HtM households’ consumption decreases my much

more than consumption of Ricardian households.

ECB Working Paper Series No 2769 / January 202331Figure 6. Inflationary supply shock: area-wide demand components

Horizontal axes: quarters; vertical axes: percent deviations from the steady state. All variables are in real terms.

0102030-1-0.50OutputWith IT0102030-0.4-0.20With ASUT0102030-1-0.50With AIT0102030-0.4-0.20Consumption0102030-0.200.20102030-0.4-0.200.20102030-4-20Investment0102030-1010102030-4-2020102030-1-0.500.5Export0102030-1-0.500102030-1-0.500.50102030-0.4-0.200.2Import0102030-0.200.20102030-0.500.5With u=2With u=0ASUT with u=3ECB Working Paper Series No 2769 / January 202332Figure 7. Inflationary supply shock: area-wide variables

Horizontal axes: quarters; vertical axes: percentage point deviations from the steady state, except wages, which
are in precent deviations. Interest rates and inflation are annualised.

0102030-0.6-0.4-0.20Average wagesWith IT0102030-0.4-0.20With ASUT0102030-0.6-0.4-0.20With AIT010203000.20.40.6Unemployment0102030-0.200.20.4010203000.20.40.6010203000.51Inflation010203000.511.5010203000.510102030-1-0.50Real rate0102030-1-0.500102030-1-0.500102030-0.200.20.4Nominal rate010203000.20.40.60102030-0.100.1With u=2With u=0ASUT with u=3ECB Working Paper Series No 2769 / January 202333Figure 8. Inflationary supply shock: country-specific demand components

Horizontal axes: quarters; vertical axes: percent deviations from the steady state. All variables are in real terms.

0102030-1-0.50OutputWith IT0102030-0.4-0.200.2With ASUT0102030-1-0.50With AIT0102030-0.6-0.4-0.20Consumption0102030-0.200.20102030-0.500.50102030-4-20Investment0102030-1010102030-4-2020102030-1-0.500.5Export0102030-1-0.500102030-1-0.500102030-0.4-0.20Import0102030-0.4-0.200.20102030-0.4-0.200.2REA, u=2REA, u=0REA, ASUT, u=3Home, u=2Home, u=0Home, ASUT, u=3ECB Working Paper Series No 2769 / January 202334Figure 9. Inflationary supply shock: country-specific variables

Horizontal axes: quarters; vertical axes: percent deviations from the steady state. All variables are in real terms.

0102030-0.6-0.4-0.20Avg. wages - Ricard.With IT0102030-0.4-0.20With ASUT0102030-0.6-0.4-0.20With AIT0102030-1-0.50Avg. wages - HtM0102030-0.4-0.200102030-1-0.50010203000.20.40.6Unempl. - Ricard.0102030-0.200.20.4010203000.20.40.6010203000.51Unempl. - HtM010203000.20.4010203000.510102030-0.6-0.4-0.200.2Real eff. exchange rate0102030-0.500.50102030-1-0.500.5REA, u=2REA, u=0REA, ASUT, u=3Home, u=2Home, u=0Home, ASUT, u=3ECB Working Paper Series No 2769 / January 202335Figure 10. Inflationary supply shock: country-specific variables

Horizontal axes: quarters; vertical axes: percent deviations from the steady state, except job finding rates and
relative consumption, which are in p.p. deviations. All variables are in real terms.

0102030-2-10Consumption - HtMWith IT0102030-1-0.50With ASUT0102030-2-10With AIT0102030-0.4-0.20Consumption - Ricardian0102030-0.200.20102030-0.4-0.200.20102030-2-10Job f. p. - HtM0102030-1010102030-2-1010102030-4-20Job f. p. - Ric.0102030-2-100102030-4-200102030-2-10C of HtM/C of Ric.0102030-1-0.500.50102030-2-101REA, u=2REA, u=0REA, ASUT, u=3Home, u=2Home, u=0Home, ASUT, u=3ECB Working Paper Series No 2769 / January 2023366 Conclusion

In this paper we analyse the concerns of policymakers regarding the degree to which central

banks should pay attention to unemployment, in addition to inflation. One reason that has been

mentioned for the importance of looking at the labour market is because of its importance for

the incomes low- and medium-income households. In the euro area, an important consideration

is also heterogeneity in labour market institutions across countries. To analyse these issues,

we build a model that has realistic features that enable us to analyse the issues faced by the

policymakers. We do so by first augmenting a global model of the euro area within the global

economy with real and nominal frictions on the labour market. Real frictions take the form of

Diamond-Mortensen-Pissarides search-and-matching frictions, which give us unemployment in

equilibrium. Then we add nominal wage rigidities using the staggered wage setting, adapted

to search models. Moreover, we distinguish between Ricardian and non-Ricardian households.

This gives us a realistic framework, with a global TANK model of the euro area with labour

market frictions that differ across types of households.

Using this augmented model we look at the performance of several monetary policy rules,

namely inflation targeting, inflation targeting with an asymmetric response to unemployment,

and average inflation targeting, where each of these rules includes some interest rate inertia,

and can respond to the inflation gap and to the unemployment gap, to different degrees. We

then analyse the performance of these rules, conditional on whether they feature the response

to unemployment gap or not, in two settings. The first setting is an expansionary aggregate

demand shock, where inflation and employment move in the same direction, so that there is no

trade-off between inflation and unemployment. The second shock we consider is an inflationary

supply shock that increases inflation and reduces employment. This shock creates a trade-off

for a central bank between stabilising inflation and unemployment.

We then compare the performance of different rules in the monetary union along several

dimensions. We investigate how do different rules affect the overall output and inflation responses

in the euro area, but then we examine in more depth how do they affect the cross-country

differences and within-country differences between Ricardian and HtM households.

Our main findings are the following. First, across all types of rules, responding to unemploy-

ment leads to lower fluctuations in unemployment and real economic activity, but with higher

inflation in the short term in the case of the supply shock. Second, across all types of rules,

ECB Working Paper Series No 2769 / January 202337assigning some weight to (un)employment tends to reduce cross-country differences within the

monetary union. Third, also across all types of rules, assigning some weight to unemployment

tends to reduce the differences in consumption levels of different types of households within the

economy. However, when the central bank does not respond to unemployment after an expan-

sionary demand shock, the difference between consumption of different types of households goes

in favour of poor HtM households, while after an inflationary supply shock this difference goes

in favour of richer Ricardian households.

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ECB Working Paper Series No 2769 / January 202341A Negative demand shock

This appendix shows the responses to a negative demand shock, where the asymmetric unem-

ployment targeting rule kicks in (unemployment rises in the case of a negative demand shock).16

Figures 11 and 12 show the euro area responses, and Figures 13 to 15 show the country-specific

responses. Recall, however, that the ASUT rule only makes sense when ϕU > 0 (if ϕU = 0, it

is identical to strict inflation targeting rule). Therefore, for a fair comparison of strict inflation

targeting rule and an ASUT rule, one should compare the dashed red lines in the left column of

the charts with the full black lines (for a moderate response to unemployment, ϕU = 2) and the

red dotted lines (for the more aggressive response to unemployment, ϕU 30) in the middle column

of the charts. At the same time, one should keep in mind that in Figures 1 to 5 the performance

of the ASUT rule is also identical to strict inflation targeting rule. This makes it clear that the

the ASUT rule preserves the benefits of expansionary demand shocks for employment, while it

mitigates the downturns in employment caused by contractionary demand shocks.

16The shock has been calibrated to achieve a 1 p.p. decrease in the euro-area-wide inflation rate at the trough.

ECB Working Paper Series No 2769 / January 202342Figure 11. Contractionary demand shock: area-wide demand components

Horizontal axes: quarters; vertical axes: percent deviations from the steady state. All variables are in real terms.

0102030-4-20OutputWith IT0102030-3-2-10With ASUT0102030-4-20With AIT0102030-4-20Consumption0102030-3-2-100102030-4-200102030-10-50Investment0102030-6-4-200102030-10-500102030-2024Export0102030-2020102030-5050102030-4-20Import0102030-4-2020102030-4-20With u=2With u=0ASUT with u=3ECB Working Paper Series No 2769 / January 202343Figure 12. Contractionary demand shock: area-wide variables

Horizontal axes: quarters; vertical axes: percentage point deviations from the steady state, except wages, which
are in precent deviations. Interest rates and inflation are annualised.

0102030-0.6-0.4-0.20Average wagesWith IT0102030-0.4-0.20With ASUT0102030-0.6-0.4-0.20With AIT010203000.51Unemployment010203000.20.40.6010203000.510102030-2-10Inflation0102030-1-0.500102030-2-100102030-1012Real rate0102030-1010102030-10120102030-1-0.50Nominal rate0102030-1-0.500102030-1-0.50With u=2With u=0ASUT with u=3ECB Working Paper Series No 2769 / January 202344Figure 13. Contractionary demand shock: country-specific demand components

Horizontal axes: quarters; vertical axes: percent deviations from the steady state. All variables are in real terms.

0102030-4-20OutputWith IT0102030-3-2-10With ASUT0102030-4-20With AIT0102030-4-20Consumption0102030-4-200102030-4-200102030-10-50Investment0102030-10-500102030-10-500102030-2024Export0102030-2020102030-5050102030-4-20Import0102030-4-200102030-4-20REA, u=2REA, u=0REA, ASUT, u=3Home, u=2Home, u=0Home, ASUT, u=3ECB Working Paper Series No 2769 / January 202345Figure 14. Contractionary demand shock: country-specific variables

Horizontal axes: quarters; vertical axes: percent deviations from the steady state. All variables are in real terms.

0102030-0.6-0.4-0.20Avg. wages - Ricard.With IT0102030-0.4-0.20With ASUT0102030-1-0.50With AIT0102030-1-0.50Avg. wages - HtM0102030-0.6-0.4-0.200102030-1-0.50010203000.51Unempl. - Ricard.010203000.20.40.6010203000.510102030012Unempl. - HtM010203000.5101020300120102030-1.5-1-0.50Real eff. exchange rate0102030-1-0.500102030-2-10REA, u=2REA, u=0REA, ASUT, u=3Home, u=2Home, u=0Home, ASUT, u=3ECB Working Paper Series No 2769 / January 202346Figure 15. Contractionary demand shock: country-specific variables

Horizontal axes: quarters; vertical axes: percent deviations from the steady state, except job finding rates and
relative consumption, which are in p.p. deviations. All variables are in real terms.

0102030-4-20Consumption - HtMWith IT0102030-4-20With ASUT0102030-4-20With AIT0102030-4-20Consumption - Ricardian0102030-4-200102030-4-200102030-6-4-20Job f. p. - HtM0102030-4-200102030-10-500102030-4-20Job f. p. - Ric.0102030-4-200102030-6-4-200102030-2-101C of HtM/C of Ric.0102030-0.500.510102030-2-10REA, u=2REA, u=0REA, ASUT, u=3Home, u=2Home, u=0Home, ASUT, u=3ECB Working Paper Series No 2769 / January 202347Acknowledgements 

The authors would like to thank the co-leads of the Strategy Review Workstream on Employment (Claus Brand, Günter Coenen, 
Reamonn Lydon, Meri Obstbaum and David Sondermann), Jelena Zivanovic, the participants of 2022 Dynare Conference, the 2022 
Computing in Economics and Finance conference, and the participants of the Strategy Review Workstream on Employment. 
The opinions expressed are those of the authors and do not reflect views of the Bank of Portugal, the Central Bank of Ireland, or the 
European Central Bank. This paper has been written while Matija was at the European Central Bank. Any remaining errors are the sole 
responsibility of the authors. 

Sandra Gomes 
Bank of Portugal, Lisbon, Portugal; UECE/REM, Lisbon, Portugal; email: sgomes@bportugal.pt 

Pascal Jacquinot 
European Central Bank, Frankfurt am Main, Germany; email: pascal.jacquinot@ecb.europa.eu 

Matija Lozej 
Central Bank of Ireland, Dublin, Ireland; email: matija.lozej@centralbank.ie 

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ISSN 1725-2806 

doi:10.2866/67943 

QB-AR-23-006-EN-N