At Last, a Coherent Theory of Involuntary Unemployment

Abstract

Mainstream macro theorists reasonably insist on coherence with mainstream microeconomics. The early Keynesian separation of macro and micro into incompatible systems has long been unacceptable. In pursuit of coherence, modern model-builders work within the common market-centric framework of dynamic stochastic general equilibrium (DSGE). The consensus model class, however, has fundamental problems, most notably including its inability to coherently accommodate involuntary job loss (especially in response to nominal demand disturbances), and consequently cannot be stabilization relevant. The inability of modern theorists to convincingly conjoin coherence and stabilization-relevance has marginalized their thinking, most recently forcing it to the policymaking sidelines during the perilous Great Recession and its aftermath. This paper shows how to restore stabilization relevance without giving up model coherence. The key to that happy outcome is the intuitive generalization of rational labor-related exchange from the marketplace to the large-establishment workplace. Two-venue general equilibrium modeling is an important, sensible innovation, introducing a powerful new frontier to macro analysis and opening up an extensive research agenda. An overview of that agenda is provided.