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Unemployment (Fears) and Deflationary Spirals

Wouter Den Haan, Pontus Rendahl () and Markus Riegler

No 10814, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: The interaction of incomplete markets and sticky nominal wages is shown to magnify business cycles even though these two features – in isolation – dampen them. During recessions, fears of unemployment stir up precautionary sentiments which induces agents to save more. The additional savings may be used as investments in both a productive asset (equity) and an unproductive asset (money). But even a small rise in money demand has important consequences. The desire to hold money puts deflationary pressure on the economy, which, provided that nominal wages are sticky, increases wage costs and reduces firm profits. Lower profits repress the desire to save in equity, which increases (the fear of) unemployment, and so on. This is a powerful mechanism which causes the model to behave differently from both its complete markets version, and a version with incomplete markets but without aggregate uncertainty. In contrast to previous results in the literature, agents uniformly prefer non-trivial levels of unemployment insurance.

Keywords: business cycles; heterogeneous agents; Keynesian unemployment; magnification; propagation; search friction (search for similar items in EconPapers)
JEL-codes: E12 E24 E32 E41 J64 J65 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-dge, nep-lab and nep-mac
Date: 2015-09
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