Coordination Failure Business Cycle Model

Motivation. The Real Business Cycle Model is good and all, but what is the Production Function doesn’t follow some of our assumptions? Notably, the assumption of decreasing returns to scale? Consider the following production function of the form:

$$Y=z{K}^{\alpha }{N}^{\beta }$$

where $\alpha +\beta \ge 1$, such that there is more increasing returns to scale.

These are called complementaries, similar to complementary goods, that more labor is able to collaborate to produce more than the sum of its parts. This will be reflected in the labor demand function as the firms will change its hiring practicies:

Now, when the complementarties are strong enough for the labor demand function to be steeper than the labor supply, we can apply the Keynesian Coordination model

Coordination Model §

We observe the two different equilibria:

1. (Blue) High interest rates $r^{+}$, low employment $N^{-}$, low production $Y^{-}$
2. (Orange) Low interest rates $r^{-}$, high employment $N^{+}$, high production $Y^{+}$ This model predicts that business cycles will be jumps between two equilibria, caused by:

• Changes in confidence in the economy
• Changes in perception of volatility
• etc.