Movements in long-term unemployment (LTU) exhibit a substantial cyclical component. I develop a business cycle model featuring labor market frictions and skill loss during unemployment to capture various stylized facts about the cyclical behavior of long-term unemployment. I find that the skill loss mechanism helps reproduce negative duration dependence, high persistence in unemployment and output, volatility patterns across macroeconomic variables and the behavior of the incidence of LTU around business cycle turning points. Optimal monetary policy in the presence of skill loss during unemployment calls for a softer reaction to inflation after productivity shocks.
The monetary authority accepts more inflation in order to avoid high skill loss during unemployment which would reduce production and hence consumption possibilities.