An Economical Business-Cycle Model

In recent decades in the US, slack on the product and labor markets has fluctuated a lot over the business cycle while inflation has been very stable. Motivated by this observation, we develop a business-cycle model in which fluctuations in demand and supply lead to fluctuations in slack but not in inflation. Our model extends the money-in-the-utility-function model by introducing matching frictions and including real wealth in 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. We use the model to study the effects of various aggregate demand and supply shocks, and to analyze several stabilization policies. As a byproduct, the model provides a microfoundation for the IS-LM model and an explanation for permanent liquidity traps with positive inflation and unemployment. Last, we combine directed search with costly price adjustments to generate a Phillips curve that describes the joint dynamics of inflation and slack in the medium run