An Economical Business-Cycle Model
abstract・In recent decades, in developed economies, slack on the product and labor markets has fluctuated a lot over the business cycle, while inflation has been very stable. At the same time, these economies have been prone to enter long-lasting liquidity traps with stable positive inflation and high unemployment. Motivated by these observations, this paper develops a simple policy-oriented business-cycle model in which (1) fluctuations in aggregate demand and supply lead to fluctuations in slack but not in inflation; and (2) the aggregate demand structure is consistent with permanent liquidity traps. The model extends the money-in-the-utility-function model by introducing matching frictions and including real wealth into the utility function. Matching frictions allow us to represent slack and to consider a general equilibrium with constant inflation. Wealth in the utility function enriches the aggregate demand structure to be consistent with permanent liquidity traps. We use the model to study the effects of various aggregate demand and supply shocks, and to analyze several stabilization policies—such as conventional monetary policy, helicopter drop of money, tax on wealth, and government spending.