TITLE:
Involuntary Unemployment and Micro-Foundations for Inflexible Aggregate Investment in Diamond-Type Overlapping Generations Models
AUTHORS:
Karl Farmer
KEYWORDS:
Involuntary Unemployment, Micro-Foundations for Aggregate Investment, Diamond-Type OLG Model, Existence, Dynamic Stability and Comparative Dynamics of Steady States
JOURNAL NAME:
Modern Economy,
Vol.14 No.4,
April
30,
2023
ABSTRACT: It is the aim of this paper to investigate the micro-foundations for
inflexible aggregate investment in Diamond-type overlapping generations (OLG)
models of involuntary unemployment. As is
well-known, in Diamond’s (1965) seminal OLG model, aggregate investment is
macro-founded in that aggregate savings govern perfectly flexible aggregate
investment. Perfect flexibility of aggregate investment precludes, however,
involuntary unemployment of the labor force: any lack of aggregate demand in
comparison to full-employment output is instantaneously compensated by flexible aggregate investment. In contrast,
inflexible aggregate investment can cause involuntary unemployment through
aggregate demand remaining below full-employment output. However, to date,
there has been no attempt in the literature to micro-found inflexible aggregate
investment in Diamond-type OLG models of involuntary unemployment. After
reviewing several approaches to micro-founding aggregate investment in
intertemporal equilibrium models with both full and underemployment, a
deterministic OLG model with production and physical capital accumulation à la Magill
and Quinzii (2003) is set up in which optimally indeterminate firm investment
and Keynes (1936) like “animal spirits” of investors are compatible. Sufficient
conditions for the existence and dynamic stability of a Golden Rule steady
state with involuntary unemployment are then presented and the comparative
dynamics of this steady state is investigated. While an increase in investor
optimism decreases unemployment in the short and long run, a smaller savings
rate does this only temporarily.