Involuntary Unemployment and Micro-Foundations for Inflexible Aggregate Investment in Diamond-Type Overlapping Generations Models

Abstract

It is the aim of this paper to investigate the micro-foundations for inflexible aggregate investment in Diamond-type overlapping generations (OLG) models of involun tary unemployment. As is well-known, in Diamond’s (1965) seminal OLG model, aggregate investment is macro-founded in that aggregate savings govern perfectly flexible aggregate investment. Perfect flexibility of aggregate investment precludes, however, involuntary unemployment of the labor force: any lack of aggregate demand in comparison to full-employm ent output is instantaneously compensated by flexible aggregate investment. In contrast, inflexible aggregate investment can cause involuntary unemployment through aggregate demand remaining below full-employment output. However, to da te, there has been no attempt in the literature to micro-found inflexible aggregate investment in Diamond-type OLG models of involuntary unemployment. After reviewing several approaches to micro-founding aggregate investment in intertemporal equilibrium models with both full and underemployment, a deterministic OLG model with production and physical capital accumulation à la Magill and Quinzii (2003) is set up in which optimally indeterminate firm investment and Keynes (1936) like “animal spirits” of investors are compatible. Sufficient conditions for the existence and dynamic stability of a Golden Rule steady state with involuntary unemployment are then presented and the comparative dynamics of this steady state is investigated. While an increase in investor optimism decreases unemployment in the short and long run, a smaller savings rate does this only temporarily.