## Introduction#

This course covers research topics related to economic slack. So what is economic slack? Economic slack describes the amount of productive resources in the economy that are unused. There are many different forms of slack: people who cannot find a job and remain unemployed; machines left idle in a factory; employed workers left idle on the job; hotel rooms, restaurants table, airplane seats that remain vacant; durable goods that cannot be sold and depreciate; perishable goods that cannot be sold and perish.

Economic slack represents a waste of productive resources, and it therefore is something that should be limited. Moreover, in addition to its wastefulness, unemployment generates other, large costs to society. People who are unemployed suffer from lower mental and physical health than employed workers. Even employed people in areas with high unemployment report lower well-being. Accordingly, good economic policy should stabilize economic slack at a desirable level and avoid periods of elevated slack.

The course is centered around formal modeling, but it also presents evidence supporting the assumptions introduced in the models. In the course we cover several models of economic slack and use them to answer several questions:

• Why does slack exist?
• How does slack affect economic life?
• Why does slack vary over time?
• How are slack fluctuations related to price and wage rigidities?
• What is the socially optimal amount of slack?
• How should monetary policy respond to fluctuations in slack over the business cycle?
• How should fiscal policy respond to fluctuations in slack over the business cycle?
• What happens at the zero lower bound?

#### Introductory video#

1. What is slack and why do we care about it?

• Krugman (2000) – This paper argues that uncomplicated models can be helpful. In this course we will develop models that are as uncomplicated as possible—and that are much simpler than models typically studied in graduate macroeconomic courses.
• Frey, Stutzer (2002) – This survey provides evidence that personal unemployment and aggregate unemployment significantly reduce happiness. The evidence refers to the pure effect of unemployment, which controls for the income loss and other inderect effects of unemployment.

This section first reviews the Kuhnian model of science. It then uses the Kuhnian perspective to understand how, over the past century, business-cycle macroeconomics evolved from the IS-LM model (inspired by Keynes’s General Theory) to the General Disequilibrium model (with nonclearing markets) to the Real Business-Cycle model (with perfectly competitive markets) and finally to the New Keynesian model (with monopolistically competitive markets).

#### Lecture videos#

• Summers (1986) – This paper discusses the origins and limitations of the Real Business-Cycle model.
• Benassy (1993) – This survey reviews the General Disequilibrium literature.
• Blanchard, Kiyotaki (1987) – This paper develops a business-cycle model with monopolistic competition that is a direct precursor to the New Keynesian model.

## Prevalence of slack and matching function#

This section documents the presence of economic slack on the labor market (unemployed workers) and on the product market (idle labor and capital). It also documents that such slack always coexists with vacant jobs and unfulfilled consumption. Then, we introduce the matching function, which is the tool that we will use to model the coexistence of unemployed workers and vacant jobs, and of idle labor and capital and unfulfilled consumption. The matching function summarizes the complex process through which workers searching for jobs meet firms searching for employees, and firms searching for customers meet consumers searching for sellers.

#### Lecture videos#

• Petrongolo, Pissarides (2001) – This survey reviews the microfoundations of the matching function, its empirical properties, and its applications.
• Shimer (2007) – This paper generates an aggregate matching function from mismatch in local labor markets.
• Montgomery (1991) – This paper generates an aggregate matching function from wage competition between firms.

## Basic model of slack#

This section develops a basic macroeconomic model of slack. The model is static. It is built around a matching function. Because of the matching function, self-employed workers are not able to sell all their services: there is always some slack. Wealth (in the form of real money balances) enters the utility function. Thanks to this assumption, and although the model is static, the aggregate demand is nondegenerate.

## Model of slack with income and wealth inequality#

This section introduces income and wealth inequality in the basic model of slack. We compute the aggregate demand and aggregate supply curves with inequality, and show how the model with inequality can be solved. In the model the marginal propensity to spend varies with slack, and the deviation from Say’s Law appears clearly.

#### Lecture videos#

• Saez, Zucman (2019) – This paper documents the rise of income and wealth inequality in the United States. The data come from distributional macroeconomic accounts.

## Discussion of the solution concept#

This section provides additional discussions of the solution concept used in the basic model of slack, and discusses an interesting special case. It also shows how the model solution is the equilibrium (in the sense from physics not economics) of a dynamical model in which households slowly learn the market tightness.

## Price and wage rigidities#

This section argues that prices and wages are not fully flexible but instead somewhat rigid. (Fairness seems to be a key reason behind price and wage rigidities.) We see how realistic pricing norms can be inserted into the basic model of slack. We also compute comparative statics in response to aggregate demand and aggregate supply shocks under fixed prices and rigid prices. We contrast these results to those obtained under bargained prices.

#### Lecture videos#

• Blinder (1994) – This paper argues, based on a survey of 200 US firms, that prices are sticky and that firms do not change prices more often by fear of antagonizing customers, who might find such price changes unfair.
• Bewley (2004) – This paper provides evidence of wage rigidity. It then argues that firms avoids pay cuts because they damage morale, which eventually reduces productivity, increases turnover, and complicates recruiting.
• Eyster, Madarasz, Michaillat (2021) – This paper develops a model of pricing in which buyers care about the fairness of markups, and firms take these concerns into account when setting prices. The model yields price rigidity and realistic Phillips curves.

## Model of slack with labor and product markets#

This section presents a model with two markets and two types of slack: a labor market with unemployment and a product market with idleness. Each market is organized around a matching function. Unemployment and idleness interact with each other. For instance, after an increase in aggregate demand, firms find more customers. This reduces the idle time of firms’ employees and thus increases firms’ labor demand. This in turn reduces unemployment.

#### Lecture videos#

• Michaillat, Saez (2015, sections 3–6) – These sections develop the model of slack with labor and product markets, and assess the sources of unemployment fluctuations in the United States.
• Diamond (2011) – This is Peter Diamond’s Nobel lecture. It discusses the applications of the matching framework to the product market and other markets.
• Wasmer, Weil (2004) – This paper develops a model of slack with labor and financial markets—each organized around a matching function.

## Dynamic model of slack#

This section presents a dynamic version of the basic model of slack. An advantage of moving to a dynamic environment is that interest rates appear into the model. Indeed, the real interest rate is a key determinant of aggregate demand. By setting a nominal interest rate, the central bank can stabilize the economy. The model is useful to quantify the effect of monetary policy on unemployment—for instance to assess the possibility of a soft landing in the aftermath of the pandemic inflation spike.

#### Lecture videos#

• Michaillat, Saez (2022, sections 1–4) – These sections develop the dynamic model of slack and perform various comparative statics.
• Michaillat, Saez (2021) – The dynamic model of slack assumes that wealth enters households’ utility function. This paper shows that introducing wealth in the utility is also helpful in the New Keynesian model. Indeed, it resolves all the anomalies of the New Keynesian model at the zero lower bound.
• Ball, Leigh, Loungani (2017) – This paper documents the prevalence of Okun’s law—the negative correlation between output and unemployment rate—in the United States since 1948. Okun’s law implies that output and market tightness are negatively correlated over the business cycle, which in turn implies that aggregate demand shocks are the main source of cyclical fluctuations.

## Social welfare, efficiency, and inefficiency#

The model of slack is generally inefficient. Except in a knife-edge case, there is too much or too little slack. This section therefore develops a simple formula for the efficient amount of slack. It shows that the US economy is generally inefficient, and is especially exceedingly slack in slumps.

#### Lecture videos#

• Michaillat, Saez (2022) – This paper derives the formula $u^\ast = \sqrt{uv}$.
• Michaillat, Saez (2021) – This paper derives a sufficient-statistic formula for the efficient unemployment rate that generalizes the formula $u^\ast = \sqrt{uv}$. The general formula involves the Beveridge elasticity, cost of unemployment, and cost of recruiting.
• Chetty (2009) – This survey describes the sufficient-statistic method for welfare and policy analysis.

## Optimal monetary policy over the business cycle#

This section describes optimal monetary policy over the business cycle. Monetary policy influences the aggregate-demand curve, so it can be used to shrink the unemployment gap. In fact, the optimal monetary policy is to adjust interest rates to eliminate the unemployment gap entirely. So the central bank should lower rates in bad times, when unemployment is inefficiently high, and raise rates in good times, when unemployment is inefficiently low.

#### Lecture videos#

• Michaillat, Saez (2022, sections 5–6) – These sections obtain the sufficient-statistic formula for optimal monetary policy and apply it to the US economy.
• Bernanke, Blinder (1993) – This paper estimates the response of the federal funds rate to unemployment, and the effect of the federal funds rate on unemployment.
• Coibion (2012) – This paper blends the narrative and VAR approaches to estimate the monetary multiplier—the effect of an increase in the federal funds rate on the unemployment rate.

## Optimal government spending over the business cycle#

This section studies optimal public expenditure over the business cycle. It shows that that optimal public expenditure deviates from the Samuelson rule to reduce, but not eliminate, the unemployment gap. The amplitude of the deviation depends on the unemployment gap, fiscal multiplier, and elasticity of substitution between public and private goods. Since the unemployment gap is countercyclical, optimal public expenditure is also countercyclical. That is, the government should spend more in bad times and less in good times.