A New Theory of Aggregate Supply

Macroeconomic theory contains two competing explanations of business cycle fluctuations. According to the intertemporal substitution mechanism (ITS), observed variations in employment represent the optimal response of labor supply to (misperceived) variations in the expected real rate of interest. A competing theory is offered by the literature on overlapping contracts that attributes employment variations to contracted nominal wage rigidities. Such rigidities prevent prices from adjusting in a way that would allow quantities to mimic the theoretical predictions of the Walrasian marketclearing model. Both of these theories incorporate the property that employment converges in the long run to a natural rate of employment. This paper develops an alternative theory. It presents a model of an economy in which agents are rational utility maximizers with perfect foresight of future prices-nevertheless the competitive equilibrium is Pareto inefficient. This situation arises because the economy does not contain a complete set of markets. Perfect capital markets do not exist because of asymmetric information (AI). A complete set of futures markets does not exist because agents have finite lives and trades cannot be negotiated with the unborn. These two sources of market failure are modeled by embedding a theory of AI contracts into an overlapping generations model (OLG) in which a critical role is played by the additional assumption that in some states of nature bankruptcy may be a binding constraint. The nonexistence of futures markets generates a model with the property that government debt is real wealth which implies that fiscal policy can have a permanent effect on the real rate of interest. The bankruptcy constraint translates changes in the rate of interest into changes in the frequency of contract default-simply stated, a high interest rate increases the probability that a firm will go bankrupt (or that it will layoff workers).' In sharp contrast to either the new classical or the sticky price contract explanations of business cycle fluctuations, this theory is not a natural rate theory even in the long run. It predicts that the steady-state employment level is an endogenous variable which varies systematically with fiscal policy.