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

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. ∗Pascal Michaillat: Department of Economics and Centre for Macroeconomics, London School of Economics, Houghton Street, London, WC2A 2AE, UK; Email: [email protected]; Web: sites.google.com/site/pmichaillat/. Emmanuel Saez: Department of Economics, University of California, Berkeley, CA, 94720, USA; Email: [email protected]; Web: elsa. berkeley.edu/∼saez/. We thank George Akerlof, Peter Diamond, Yuriy Gorodnichenko, Camille Landais, Kristof Madarasz, Alan Manning, and Kevin Sheedy for their valuable comments and suggestions. The paper has also benefited from helpful conversations with seminar participants at the London School of Economics. Financial support from the Center for Equitable Growth at the University of California, Berkeley is gratefully acknowledged. Michaillat gratefully acknowledges support from the W.E. Upjohn Institute for Employment Research through Early Career Research Grant #12-137-09.