Large Employment Fluctuations with Product- and Labor-Market Equilibrium

The current slump has repeated on an unusual scale the large movements of quantities and tiny movements of wages and prices that often characterize the business cycle. The only price that moved signicantly was the interest rate, which plunged to zero in nominal terms and into negative territory in real terms. I build a model that describes these outcomes as a full equilibrium without limitations on the immediate movements of prices or wages. Even when the nominal interest rate is pinned at zero and unemployment is high, the model is in full equilibrium, a property absent from earlier models of the zero lower bound. A key feature of the model is that unemployment is a fast-moving variable that takes over the role of clearing product markets that the interest rate normally plays, once the rate hits zero. I describe the conditions that allow the unemployment rate in the Diamond-Mortensen-Pissarides framework to match the rate as elevated by the binding zero lower bound. I argue that the conditions are plausible. Monetary policy plays a key role in the model|because of the zero lower bound, real activity is not invariant to monetary policy despite the full equilibrium character of the model.