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A Theory of Aggregate Supply and Aggregate Demand as Functions of Market Tightness with Prices as Parameters

Author

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  • Emmanuel Saez

    (UC Berkeley)

  • Pascal Michaillat

    (London School of Economics)

Abstract

This paper presents a parsimonious equilibrium business cycle model with trade frictions in the product and labor markets. The model features unemployment and unsold production and its general equilibrium can be represented very simply: as the intersection of an aggregate supply and an aggregate demand, with product market tightness acting as a price. The aggregate supply represents the expected amount of sales by firms given product market tightness and optimal hiring on the labor market. The aggregate demand represents optimal product consumption given product market tightness--consumers can also spend their income on an unproduced good. We use a search-andmatching structure to realistically represent trade frictions in the product and labor markets. In such a structure, it is not price or wage but market tightness that equalizes supply to demand. In fact, the frictions create situations of bilateral monopoly in price and wage setting that make price and wage indeterminate. To resolve this indeterminacy, we take price and wage as parameters, thus disconnecting price and wage determination from our analysis. Since the equilibrium representation is very transparent and tractable, we are able to obtain a broad range of comparative statics with respect to demand and supply shocks. The model is also suited to think about inventories, labor hoarding, income and wealth inequality. It can be extended to a dynamic environment.

Suggested Citation

  • Emmanuel Saez & Pascal Michaillat, 2013. "A Theory of Aggregate Supply and Aggregate Demand as Functions of Market Tightness with Prices as Parameters," 2013 Meeting Papers 1216, Society for Economic Dynamics.
  • Handle: RePEc:red:sed013:1216
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    References listed on IDEAS

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    Cited by:

    1. Pascal Michaillat, 2014. "A Theory of Countercyclical Government Multiplier," American Economic Journal: Macroeconomics, American Economic Association, vol. 6(1), pages 190-217, January.
    2. Mirko Abbritti & Tommaso Trani, 2014. "Search and Bargaining in the Product Market and Price Rigidities," Faculty Working Papers 09/14, School of Economics and Business Administration, University of Navarra.
    3. Den Haan, Wouter, 2013. "Inventories and the Role of Goods-Market Frictions for Business Cycles," CEPR Discussion Papers 9628, C.E.P.R. Discussion Papers.
    4. Wouter Den Haan, 2014. "Inventories and the Role of Goods-Market Frictions for Business Cycles," Discussion Papers 1402, Centre for Macroeconomics (CFM).

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