Macroeconomic Fluctuations and Inequality

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.

We expect the proposed research to have a broad impact, both in academia and among policymakers. The Academic Beneficiaries section of the grant proposal focuses on the impact of the proposed research in academia. It explains that by developing a simple and realistic model of macroeconomic fluctuations that accounts for unemployment and other sources of inequality, the research will benefit economists in various fields.

This document focuses on the impact of the proposed research outside academia. Outside academia, three types of policymakers will directly benefit from the research: policymakers in international institutions such as the International Monetary Fund, who implement broad sets of policies to tackle recessions; policymakers in governments, who implement fiscal policy and social insurance programs; and policymakers in central banks, who conduct monetary policy.

These policymakers will benefit from three outputs of the project: theoretical policy arguments, developed in research papers; the toolbox of computer programs usable to simulate the effects of various policies; and policy recommendations, summarized in a book.

We expect the theoretical arguments and results in the papers to influence policymakers. Indeed, policymakers use relevant academic research to substantiate arguments they have in favour and against different policy options. For instance, our paper on optimal unemployment insurance was cited to support the case for extending unemployment benefits in a hearing of the US Senate Budget Committee in 2011 (see attached congressional testimony).

We also expect that policymakers worldwide will use and benefit from the toolbox of computer programs that we will develop and make available online. Using the toolbox, they will be able to benchmark their policy options and assess the quantitative effect of proposed policies in our calibrated macroeconomic model. They will be able to answer practical questions such as:

- What is the effect on unemployment of an increase in the replacement rate of unemployment insurance by 10%?

- What is the effect on hiring and profits of a cut in the employer payroll tax rate by 3%?

As explained in Pathways to Impact, I will solicit the views of policymakers to ensure that the toolbox is useful to them.

We expect policymakers to benefit from our book. The book will summarize the findings from the research and benchmark policy options with case studies. It will also offer a set of actionable policy prescriptions to fight unemployment and recessions in presence of inequality. With the book, these audiences will learn about new policy options to fight recessions. In practice, the book will address a broad range of policy questions. By answering these questions, the research will provide direct guidance for many practical policy decisions faced by policymakers in times of recessions. Such questions include:

- Should unemployment insurance be more generous in recessions to stimulate aggregate demand? Or should it be less generous to incentivise unemployed workers to search harder 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 labour costs 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?

Finally, if the project were successful and improved the practice of macroeconomic policy, society at large would benefit. By reducing unemployment and inequality, the policies would promote a fair society with many opportunities