In the aftermath of the 2008 financial crisis, unemployment increased dramatically in most Western economies. Five years after the financial crisis, the unemployment rate remained above 7% in the US and in the UK, and above 10% in the Eurozone. Policymakers have been unable to reduce unemployment in part because abstract modern macroeconomic models provide limited guidance for the conduct of actual macroeconomic policy in recessions. Furthermore, high levels of income and wealth inequality seem to have precipitated and aggravated the current recession. It is difficult for practitioners to use modern macroeconomic models to understand recessions and develop policies because of two gaps in modern macroeconomic theory. First, the theory does not capture departures from perfectly competitive markets in a realistic and tractable fashion. Second, the theory assumes away inequality by making one of the following assumptions: a representative household owns all firms; profits of firms are fully taxed and rebated to households; or there are no profits in equilibrium. This project fills these two gaps by developing a simple macroeconomic model that captures transparently the features of actual business cycles. The model marries a careful treatment of unemployment and aggregate demand, inspired by Keynes, with the sophisticated treatment of aggregate supply proper to modern general-equilibrium models. Additionally, the model incorporates distributional issues.
Macroeconomic Policy over the Business Cycle