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What is Keynesian Search Theory?

Summary:
I've been asked recently how my work on search theory differs from the approach pioneered by Peter Diamond, Dale Mortensen and Chris Pissarides (DMP). I call the DMP approach classical search theory, and in my book Prosperity for All, I distinguish classical search theory from a new approach; Keynesian Search Theory, that I introduced in ...

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What is Keynesian Search Theory?

I've been asked recently how my work on search theory differs from the approach pioneered by Peter Diamond, Dale Mortensen and Chris Pissarides (DMP). I call the DMP approach classical search theory, and in my book Prosperity for All, I distinguish classical search theory from a new approach; Keynesian Search Theory, that I introduced in my paper Aggregate Demand and Supply, published in 2008. I coined the term Keynesian search theory, in Prosperity for All, to clarify the distinction between my work and previous literature. If a macro model is closed with classical search theory, beliefs are determined by economic fundamentals. If a macro model is closed with Keynesian search theory, beliefs represent a new fundamental that is determined by the psychology of market participants. I call this new fundamental; the belief function.

Here's how I described this issue in a post on this blog in 2014

"Until recently, new-Keynesian economists didn't bother to model unemployment. Instead, they followed the new-classical approach in which all that matters is labor hours spent in paid employment. More recently, a number of authors including  Bob Hall, and Mark Gertler and Antonella Trigari have incorporated explicit models of search unemployment into otherwise standard macroeconomic DSGE models. ...  What is different about more recent work ...  [in classical search theory, that builds] ...on Hall's 2005 paper, is the way the model is closed. 

... When a firm meets a worker in a search model, the worker and the firm enter a bilateral bargaining situation. The worker would be willing to accept a job, and the firm would be willing to employ the worker, for any wage that is greater than the worker's reservation wage and less than the worker's marginal product. In his 2005 paper, Bob showed that one way to close the model, is to assume that the wage is fixed.

...That way of attacking the problem is, ... [in my view] ... a mistake. The new-Keynesians are squeezing the square peg of labor market search theory into the round hole of Samuelson's  neoclassical, synthesis. 

... An alternative approach, that has a better shot at understanding the data, ... [is to drop] ... the bargaining assumption completely and ...  [ to assume instead ] ... that firms and workers are price takers in the labor market..."

In classical search theory, firms and workers bargain over the wage, and the value of a firm depends on the outcome of the bargaining process. Expectations about the value of assets, aka beliefs, must ultimately be consistent with labor market fundamentals.

In Keynesian search theory, this process is turned on its head. Market psychology is a new independent fundamental that determines asset prices and the division of the product, between workers and firms, must ultimately be consistent with asset market beliefs. In this new way of seeing the world, market psychology is a new causal factor.

Here is how I presented the contrast between these approaches in Prosperity for All [Page 121]:

"[Keynesian search theory] explains permanent shocks to the unemployment rate as inefficient shifts from one unemployment equilibrium to another. If I am right, we can and should try to counteract permanent shocks to the unemployment rate by active intervention in which the central bank, acting as an agent for the treasury, buys or sells shares in the stock market to smooth out financial fluctuations."

As I argue in this video, Keynesian search theory offers the promise of a marriage between psychology and economics. Classical search theory does not. If you are young, ambitious and uncorrupted by tired establishment views, consider joining me in developing a truly interdisciplinary approach to the future of macroeconomics.

Roger Farmer
ROGER E. A. FARMER is a Distinguished Professor of Economics at UCLA and served as Department Chair from July 2008 through December 2012. He was the Senior Houblon-Norman Fellow at the Bank of England, January-December 2013.

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