A central goal of Discussion Paper No. 1206, written by Research Affiliate Jordi Galí, is the development and analysis of a stochastic dynamic equilibrium model that is capable of accounting for the presence of unemployment and the following stylized facts of labour markets: employment is highly procyclical and about as volatile as GNP; labour force measures are procyclical and substantially less volatile than employment and GNP; and unemployment rates are highly countercyclical and about half as variable as GNP.

For this purpose, a real business cycle model is developed in which both goods and labour markets are characterized by imperfect competition. Workers have market power because of the assumption that the firm is unable to hire 'outsiders' to replace incumbent workers. For simplicity, it is assumed that technology shocks are the only source of fluctuations. A calibrated version of the model is analysed and its implied statistical properties for a number of macroeconomic time series are compared to those observed in the data. It is claimed that the model can generate both a procyclical labour supply and a countercyclical unemployment rate. But none of the alternative parameter calibrations of the model appear to be able to match certain key quantitative properties of the unemployment rate observed in the data. The basic source of this failure seems to be an insufficient employment volatility.

Real Business Cycles with Involuntary Unemployment
Jordi Galí

Discussion Paper No. 1206, June 1995 (IM)