Behavioural macroeconomics: time, optimism and animal spirits

The 2007-8 financial crisis precipitated growing disillusionment with standard macroeconomictools and models. The most influential macroeconomic models in policy terms are the dynamicstochastic general equilibrium (DSGE) models which assume forward looking agents facingrandom events within a general equilibrium framework focusing on complete sets of interactingmarkets, as opposed to a partial equilibrium approach analysing one market at a time. Of the twoforms in which DSGE models are generally seen, monetarist/neoclassical versus New Keynesianversions, both are dependent on narrow conceptions of economic behaviour and rationality, andboth are founded on rigorous micro-foundations. Neoclassical and monetarist models assumeperfect competition in smooth running markets with many buyers and sellers, flexible prices,perfect information and market-clearing-and these assumptions are applied to labour markets aswell as goods markets. In this world, unemployment is voluntary, reflecting a worker’s choiceabout working only when the equilibrium real wage is large enough for workers to give up theirvaluable leisure time. Traditionally, Keynesian models focused on involuntary unemploymentand sticky prices and New Keynesian models blend these insights with a softening of some of thestrict assumptions associated with neoclassical and monetarist models to allow for imperfectinformation, sticky prices and transaction costs, including menu costs-and via these routes allowfor involuntary unemployment: imperfectly competitive wage bargaining generates labourmarkets in which the real wage set by negotiations between employers and insiders (and theirunions) is too high to clear the labour market. Involuntary unemployment of outsiders excludedfrom wage bargaining is the consequence of this insider-driven wage bargaining process.