Macroeconomic Fluctuations and Inequality

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In the aftermath of the 2008 financial crisis, unemployment increased dramatically in Western economies. More than four years after the financial crisis, the unemployment rate remains above 8% in the US and the UK, and above 11% in the eurozone. This period of rampant unemployment demonstrates that we do not have the policies to fight unemployment effectively, especially in a world with growing inequality. By developing a policy-friendly macroeconomic theory substantiated by empirical evidence, the project will provide some guidance for the design of macroeconomic policies able to reduce unemployment in recessions while alleviating inequality. The goal of the proposed project is to bridge the existing gap between abstract macroeconomic models and actual macroeconomic policy. This gap explains in part why policymakers have been unable to reduce unemployment. In fact, existing models provide little guidance for the conduct of macroeconomic policy in recessions. Furthermore, large income and wealth inequality seem to have precipitated and aggravated the current recession. But these models abstract almost completely from inequality.To achieve our goal, we will develop a new kind of macroeconomic model that captures transparently the features of actual business cycles, in particular by incorporating wealth and income inequality. We will use the model to address theoretically various policy questions: - Should unemployment insurance be more generous in recessions to stimulate aggregate demand? Or should it be less generous to incentivise unemployed workers to search more intensively for jobs?- Should payroll tax shift from employees to employers in recessions to stimulate aggregate demand by transferring income from firm owners to workers? Or should it shift from employers to employees to reduce the cost of labour and stimulate hiring?- Should income tax be more progressive in recessions to stimulate aggregate demand by transferring income from the rich to the poor? Or should it be more regressive to encourage work and entrepreneurship?- Should the government hire workers in the public sector in recessions to reduce unemployment? Or should it fire public workers to reduce public debt and stimulate private enterprise? We will complement the theoretical analysis with numerical simulations of the model using real-world data. The project has a strong potential for impact. Our project will develop a simple macroeconomic model that marries a careful treatment of unemployment and aggregate demand, inspired by the work of Keynes, with the sophisticated treatment of aggregate supply proper to modern macroeconomic models. Additionally, the model will incorporate wealth and income inequality. The model will therefore be useful to many economists in academia. But we hope that the impact of the project will not be limited to academia. By delivering actionable policy prescriptions to fight unemployment and recessions in presence of inequality, we expect the project to have a substantial impact in policymaking institutions. If the project were successful and improved the practice of macroeconomic policy, it would also have a major positive impact on society. Finally, this project is a scientific collaboration with Emmanuel Saez. Emmanuel is the leading economist on the subject of inequality. He is based at the University of California, Berkeley. We will prepare three outputs to disseminate research findings: (1) papers published in academic journals; (2) a toolbox of computer programs available usable by policymakers to benchmark various policy options; and (3) a book compiling research findings and prescriptions for the conduct of macroeconomic policy in recessions. Although the papers are primarily aimed at academics, we expect their theoretical arguments to reach policymakers. The toolbox of computer programs and the book are specifically designed for policymakers.