Primer: Labor Markets In Neoclassical Models

The labor market is a key driver for business cycles. Within standard economic models where production is mainly a function of capital and labor (and productivity which determines the multiplier from these inputs), given that productivity is normally fairly stable, we can only generate a recession via a drop in employment. (The recession of 2020 provides an example of "productivity" dropping as a result of governments shuttering activity, but even then, the mechanism for lower production was stopping workers from going to work. This could be captured in any number of ways within a model.)

My comments here are fairly generic, but I am using the paper "Confidence, Crashes and Animal Spirits" by Roger E. A. Farmer* as an example one could look at. I am certainly not in a position to authoritatively survey the neoclassical literature, but my comments here are based on a sampling of benchmark models.

Money, Burn, Dollar, Waste, Finance, Fire, Investments

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Utility Maximization

The basic premise of neoclassical dynamic stochastic general equilibrium (DSGE) macro models is that we somehow find the solution to multiple optimization problems. Typically, there is at least a household sector and business sector that are attempting to generate an optimal outcome. In this article, I am largely ignoring the business sector optimization problem, on the grounds that maximizing profits is a relatively easily understood idea.

For the household sector, there are representative households (some model structures can allow heterogeneous agents) that attempt to maximize their utility. The utility function is based on consumption over the model horizon, typically an infinite horizon, or possibly in terms of a generation's lifetime (in an overlapping generations model). Although heterodox critics mock the infinitely long-lived representative agent, I find it less problematic than overlapping generations models. (The paper I from Roger Farmer noted earlier is based on a representative agent, while he has co-authored a more recent article that provides an overlapping generations version.)

The decisions to be optimized by the household is to choose how many hours to work, and how many units of produced goods (there is a single representative good) to consume. Working provides wages to allow goods purchases, but the household will also have financial assets to use to finance consumption. These financial assets are typically either money, bonds (typically one period Treasury bills that pay the nominal interest rate that the central bank sets via a reaction function), and possibly claims on capital. 

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Disclaimer: This article contains general discussions of economic and financial market trends for a general audience. These are not investment recommendations tailored to the particular needs of an ...

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