Modelling Involuntary Unemployment in Applied GE Models

Involuntary unemployment is a regrettable feature of the world, but not of most general equilibrium models. Standard attempts to incorporate involuntary unemployment into such models have rested on mechanistic and arbitrary assumptions about wage rigidity. This paper recognises that the difficulty of modelling the reality of involuntary unemployment is that the currently used models lack a crucial piece of information: the role that the level of unemployment plays in labour market decisions. This paper outlines a theory in which unemployment rates enter into the decision making process of individual agents which in turn yields the missing equation. It then draws on the empirical literature to parameterise it and incorporates this equation in the GTAP model to derive a dynamic GTAP model with endogenous unemployment (DGTAPU). The model is then simulated with a number of stylised scenarios and illustrative results are presented. It is hoped that this paper will induce additional research in improving the specification of the ‘new’ equation and the precision of policy analysis.