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  Blanchard and Gali Tackle the Job Loss Puzzle

  By James Annable | Jun 18, 2021

   

  New Keynesian theory, the go-to model in modern macroeconomics, is a quagmire of seemingly insoluble puzzles. Readers of this Blog know that much of the difficulty is rooted in the New Neoclassical Synthesis, the academy’s governing directive for acceptable research. In particular, the NNS mandates use of friction-augmented general market equilibrium, which produces much more mild recessions than consistent with the evidence. The best-known  NK  shortcoming is the employment-volatility puzzle: FGME modeling generates much smaller increases in joblessness in cyclical downturns than does the real world. Additional business-cycle characteristics that escape the analytic grasp of NNS theorists include meaningful wage rigidity, involuntary job and income loss, chronic wage rents that motivate unemployment persistence, chronic market inefficiency, money non-neutrality sufficient to justify discretionary management of total nominal spending, an evidence-consistent trade-off between unemployment and inflation, extreme instability and depression rooted in rational behavior, rational-behavior stagflation, and more. Simply put, the mainstream NNS framework does an embarrassingly shoddy job of explaining policy-relevant features of business cycles.

  This post’s selective look at unresolved mainstream puzzles considers the adverse employment and production fluctuations generated in the FGME model class, concluding it can never produce policy-relevant instability. At the heart of that problem are inherent limitations of NK search/match modeling that is almost always used in FGME analysis to provide behavioral content to labor-market behavior.

  Mainstream job-loss modeling. NK research on downward nominal wage rigidity, a necessary condition of involuntary job loss, is fatally focused on identifying one or more market frictions that rationally suppress labor-price recontracting. Decades of failure indicate that the hoped-for super friction does not exist. Illustrative of that continuum of disappointment is the relatively recent attempt by Blanchard and Gali (2010 )to come up with a plausible super friction.

  Blanchard-Gali’s fate is sealed with their assignment of a central role to the familiar labor wedge, asserting that market frictions induce a wage band within which any real labor price is consistent with private efficiency: MRS≤W≤MPL. MRS denotes...

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