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THE
QUARTERLY JOURNAL
OF ECONOMICS
Vol. C 1985 Supplement
A NEAR-RATIONAL MODEL OF THE BUSINESS CYCLE,
WITH WAGE AND PRICE INERTIA*
GEORGE A. AKERLOF AND JANET L. YELLEN
I. INTRODUCTION
This paper offers an explanation of why changes in the nom-
inal supply of money are not neutral in the short run. It shows
that aggregate demand shocks can cause significant changes in
output and employment if agents adjust wages and prices in ways
which are "insignificantly" suboptimal from their individual
standpoints. Alternatively, very small transaction costs of deci-
sion making or changing prices could account for large fluctua-
tions in real economic activity.
The argument proceeds in six steps.
1. The propertyof nonneutrality is shown to be important for
business cycle theory.
2. The concept of near-rationality is introduced. Near-ra-
tional behavior is nonmaximizing behavior in which the gains
*This is a revised version of Akerlof and Yellen [1983]. The authors would
like to thank Andrew Abel, Alan Blinder, Richard Gilbert, Hajime Miyazaki,
John Quigley, James Tobin, and James Wilcox for helpful conversations. The
researchfor this paper was supportedby National Science FoundationGrant No.
SES 81-19150 administeredby the Institute for Business and EconomicResearch
of the University of California, Berkeley.
? 1985 by the President and Fellows of Harvard College. Published byJohn Wiley & Sons, Inc.
The QuarterlyJournal of Economics, Vol. 100, Supplement, 1985
824 QUARTERLY JOURNAL OF ECONOMICS
The real wage X is chosen at the optimizing level w*, where the
elasticity of effort with respect to the real wage is unity. (This is
a standard result in such models [Solow, 1979] and represents the
condition that the firm chooses the real wage that minimizes the
unit cost of a labor efficiency unit.)
With this choice of real wage o*, the demand for labor is
(7) No = k-Ve(oM.
(8) pn = po
(9) Wm= <*
(10) pm = po(l + F)0,
where
= (1 -a)I
3(n/qa- -q + 1) + (1 - i) ((1 a)/a)
(11) = Po (1 +
P P)(1-0)
=)*(1
- + 8) (1 P)O: the money wage paid by the nonmaxi-
mizing firm is unchanged at its initial
value wo. The real wage is, accordingly,
wo/p, which can be rewritten as the prod-
uct (wolpo)(poI).The first term of this
product is ,*, and the second is
(1 + 6)-(1 - o
ing that the derivative of the difference between [Jm and -Inwith
respect to E vanishes for E = 0.
The derivative of lm - Jun with respect to E can be grouped
into four separate terms, each one corresponding to one set of
curly brackets in (15):
d(flIn - flfl) _
d dAl = { (1- l) (pm(E))-f(F) +
(sf)
X (pm (F)) - q't- g (F,)w*(e(wX*))
- }d-m
Jde
(15) + {o*[e(h(F)w*)]- 1 - h(F)w*'e'(h(F)w*)
x[ (h()w*)]-} (PO)-1/?g(E)
The first term in curly brackets in (15) is zero because of the first-
order condition for pmas the maximand of the profit function Jm.
The second term in curly brackets vanishes for E equal to zero,
since h(W)= 1, and since a* has been chosen to maximize profits.
(This causes w*e'(w*)[e(w*)]-lto equal unity.) Thus, the first two
terms in curly brackets in (15) are zero for E equal zero because
of the optimizing choice of the respective variables, p and W.The
third and fourth terms in curly brackets cancel for,Eequal to zero,
because pm(O)= po and h(O) = 1. These terms reflect the common
effect of E on Hm and f[n. Since all four terms in curly brackets
either vanish or cancel for E equal zero, it follows that
6d(m d- fln)
~
(16) = 0.
This is a key result of this paper. It says that the loss to the
nonmaximizers over their maximum possible profits in this model
is second order with respect to e. It also follows trivially that this
loss in percentage terms is equal to zero for E equal zero and has
a derivative of zero.
Employment
The elasticity of total employment, with respect to changes
in the money supply is not zero. For E equal zero, this elasticity
can be calculated as
836 QUARTERLYJOURNAL OF ECONOMICS
d(NINo)_
d =- 1 (1 - (1 -
(17) )0) + 13(1-1)0.
de a
Two comments are in order about (17). First, since 0 is less than
one, an increase in the money supply causes an increase in em-
ployment. Also, since 0 = 1 for 13= 0, the elasticity of employ-
ment with respect to changes in the money supply vanishes as
the fractionof nonmaximizersapproacheszero.Such a result should
be expected, since as 1 approaches zero, the model approaches
one of monetary neutrality.
Simulations
We did some simulations of the preceding model of unem-
ployment for various values of the elasticity of output with respect
to labor input (a), the elasticity of demand for each firm (,q),and
the fraction of nonmaximizers (1). The parameters of the wage-
effort function, a, b, and y, were chosen equal to 1.0, 2.0 and 0.5,
respectively, so that w*[e(w*)]-b would conveniently equal one.3
For each set of parameter values, Table I reports the per-
centage difference between the profits of maximizers and non-
maximizers for changes in the money supply, which, respectively,
produce 5 percent and 10 percent increases in employment. For
5 percent changes in employment, all values but one, even for
values of -q (the elasticity of demand) as large as 100, are less
than 1 percent. For changes in employment of 10 percent, these
differences are mainly below 1 percent for low values of aq,and,
at the maximum value in the table, for a = 0.75, -q = 100, and
13= 0.25, only reaches 5.05 percent. Although this loss in profits
is extreme in the table, it is not beyond the bounds of possibility.
Quite conceivably, over the course of the business cycle, a quarter
of all firms could fail to correct a policy that caused a 5 percent
loss in profits.
III. CONCLUSION
In conclusion, a model has been presented in which changes
in aggregate demand cause significant changes in equilibrium
output. This model meets Lucas' criterion that there are "no$500
TABLE I
PERCENTAGELoss IN PROFITSDUE TO NONMAXIMIZINGBEHAVIORFOR
DIFFERENTPERCENTAGECHANGES IN EMPLOYMENT,ELASTICITYOF OUTPUT WITH
RESPECTTO LABOR INPUT (a), ELASTICITYOF DEMAND (Ti), AND PROPORTIONOF
(13)
NONMAXIMIZERS
ax= 0.25
= 1.5 0.084 0.023 0.011 0.309 0.088 0.043
T= 3.0 0.220 0.059 0.028 0.808 0.226 0.107
= 5.0 0.298 0.079 0.036 1.090 0.303 0.142
T= 20.0 0.408 0.107 0.049 1.496 0.410 0.189
= 100.0 0.443 0.116 0.052 1.623 0.442 0.203
x = 0.5
= 1.5 0.088 0.024 0.012 0.330 0.092 0.045
= 3.0 0.295 0.080 0.038 1.109 0.306 0.146
= 5.0 0.459 0.122 0.057 1.726 0.471 0.222
= 20.0 0.768 0.201 0.091 2.892 0.774 0.356
= 100.0 0.888 0.231 0.104 3.343 0.889 0.405
a = 0.75
a= 1.5 0.046 0.012 0.006 0.175 0.045 0.021
T = 3.0 0.207 0.054 0.025 0.796 0.209 0.097
T= 5.0 0.397 0.103 0.048 1.533 0.402 0.186
T= 20.0 0.974 0.251 0.114 3.769 0.979 0.447
T= 100.0 1.304 0.334 0.151 5.046 1.304 0.591
a = 1.0, b = 2.0, y = 0.5.
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