A new keynesian model with unemployment

A New Keynesian model with unemployment! That's a great topic.

In a New Keynesian model, we assume that the economy is characterized by sticky prices and wages, which means that firms and workers do not adjust their prices and wages instantaneously in response to changes in the economy. This stickiness leads to a departure from the classical notion of full employment, where the labor market clears at a unique equilibrium wage and employment level.

Here's a simple New Keynesian model with unemployment:

Assumptions:

  1. The economy is a small open economy with a fixed exchange rate.
  2. The government sets a constant money supply (M) and a constant interest rate (r).
  3. Firms are price-setters, and wages are sticky.
  4. Workers are price-takers, and their labor supply is a function of the wage rate.
  5. The labor market is characterized by a trade-off between employment and unemployment.

Model Structure:

  1. Aggregate Demand (AD) Equation:

The aggregate demand equation is a function of the interest rate (r), the price level (P), and the money supply (M):

AD = C(Y - T) + I(r) + G

where C is the marginal propensity to consume, Y is the real GDP, T is the government transfer, I is the investment function, and G is the government spending.

  1. Aggregate Supply (AS) Equation:

The aggregate supply equation is a function of the wage rate (w) and the price level (P):

AS = N(w, P)

where N is the labor supply function, which is a function of the wage rate and the price level.

  1. Labor Market Equilibrium:

The labor market equilibrium is determined by the intersection of the labor demand curve (LDC) and the labor supply curve (LSC):

LDC = N(w, P)

LSC = N(w, P)

The labor market equilibrium is characterized by a unique wage rate (w) and employment level (N) that satisfy the above equations.

Unemployment:

Unemployment occurs when the labor market is not in equilibrium. There are two types of unemployment:

  1. Frictional Unemployment: This type of unemployment occurs when workers are transitioning between jobs or entering the labor market for the first time. Frictional unemployment is a natural part of the labor market adjustment process.
  2. Structural Unemployment: This type of unemployment occurs when there is a mismatch between the skills and qualifications of workers and the requirements of available jobs. Structural unemployment is often caused by changes in technology, globalization, or shifts in consumer demand.

Policy Implications:

The New Keynesian model with unemployment suggests that monetary and fiscal policy can be used to stabilize the economy and reduce unemployment. For example:

  1. Monetary Policy: An expansionary monetary policy (lowering interest rates) can increase aggregate demand, reduce unemployment, and stimulate economic growth.
  2. Fiscal Policy: An expansionary fiscal policy (increasing government spending or cutting taxes) can also increase aggregate demand, reduce unemployment, and stimulate economic growth.

However, the model also suggests that there are limits to the effectiveness of policy interventions. For example, if the labor market is characterized by structural unemployment, policy interventions may not be able to fully eliminate unemployment.