Abstract

The 2007–8 financial crisis precipitated growing disillusionment with standard macroeconomic tools and models. The most influential macroeconomic models in policy terms are the dynamic stochastic general equilibrium (DSGE) models which assume forward looking agents facing random events within a general equilibrium framework focusing on complete sets of interacting markets, as opposed to a partial equilibrium approach analysing one market at a time. Of the two forms in which DSGE models are generally seen, monetarist/neoclassical versus New Keynesian versions, both are dependent on narrow conceptions of economic behaviour and rationality, and both are founded on rigorous micro-foundations. Neoclassical and monetarist models assume perfect competition in smooth running markets with many buyers and sellers, flexible prices, perfect information and market-clearing—and these assumptions are applied to labour markets as well as goods markets. In this world, unemployment is voluntary, reflecting a worker’s choice about working only when the equilibrium real wage is large enough for workers to give up their valuable leisure time. Traditionally, Keynesian models focused on involuntary unemployment and sticky prices and New Keynesian models blend these insights with a softening of some of the strict assumptions associated with neoclassical and monetarist models to allow for imperfect information, sticky prices and transaction costs, including menu costs—and via these routes allow for involuntary unemployment: imperfectly competitive wage bargaining generates labour markets in which the real wage set by negotiations between employers and insiders (and their unions) is too high to clear the labour market. Involuntary unemployment of outsiders excluded from wage bargaining is the consequence of this insider-driven wage bargaining process.