An Economical Business-Cycle Model

TL;DR

This paper introduces a simple, aggregate demand-supply based business-cycle model incorporating unemployment through matching functions and wealth effects, analyzing optimal monetary policy and the role of wealth taxes during zero-lower-bound episodes.

Contribution

It presents a novel, economical model of business cycles that includes unemployment dynamics and wealth effects, providing insights into monetary policy and zero-lower-bound management.

Findings

Optimal monetary policy sets interest rates to eliminate unemployment gaps.

Wealth taxes can address large unemployment gaps when interest rates hit zero.

The model captures fluctuations driven by shocks and policy interventions.

Abstract

This paper develops a new model of business cycles. The model is economical in that it is solved with an aggregate demand-aggregate supply diagram, and the effects of shocks and policies are obtained by comparative statics. The model builds on two unconventional assumptions. First, producers and consumers meet through a matching function. Thus, the model features unemployment, which fluctuates in response to aggregate demand and supply shocks. Second, wealth enters the utility function, so the model allows for permanent zero-lower-bound episodes. In the model, the optimal monetary policy is to set the interest rate at the level that eliminates the unemployment gap. This optimal interest rate is computed from the prevailing unemployment gap and monetary multiplier (the effect of the nominal interest rate on the unemployment rate). If the unemployment gap is exceedingly large, monetary policy cannot eliminate it before reaching the zero lower bound, but a wealth tax can.