On Persistent Demand Shortages: A Behavioural Approach

Abstract

We incorporate two sets of behavioural assumptions, fairness concerns and insatiable desire for money, into a dynamic optimization model to illuminate how they can generate persistent aggregate demand shortages. We obtain the conditions for persistent unemployment and temporary unemployment. Policy implications differ significantly between the two cases. A monetary expansion raises private consumption under temporary unemployment but not under persistent unemployment. A fiscal expansion may or may not increase short-run private consumption but crowds out long-run consumption under temporary unemployment. Under persistent unemployment, however, a fiscal expansion always increases private consumption. The “paradoxes of toil and flexibility” also appear.