Unemployment (fears) and deflationary spirals

The interaction of incomplete markets and sticky nominal wages is shown to magnify business cycles even though these two features – in isolation – dampen them. During recessions, fears of unemployment stir up precautionary sentiments which induces agents to save more. The additional savings may be used as investments in both a productive asset (equity) and an unproductive asset (money). The rise in demand for the unproductive asset has important consequences. In particular, the desire to hold money puts deflationary pressure on the economy which, provided that nominal wages are sticky, increases labor costs and reduces firm profits. Lower profits repress the desire to save in equity, which increases (the fear of) unemployment, and so on. This is a powerful mechanism which causes the model to behave differently from its complete markets version. In our framework, the deflationary pressure yields a mean- reverting reduction in the price level, which implies an increase in expected inflation and a decrease in the expected real interest rate even if the policy rate does not adjust. Thus, our mechanism is different from the one emphasized in the zero lower bound literature. Due to the deflationary spiral our model also behaves differently from its incomplete market version without aggregate uncertainty, especially in terms of the impact of unemployment insurance on average employment levels.