The Great Vacation: Recessions In DSGE Models (Part I) —Brian Romanchuk

Neoclassical models are built around optimising behaviour. The logic for this is somewhat reasonable: one should expect the private sector to look out after its own interests, and not be tricked by policymakers into self-defeating behaviour. The aspiration is hard to argue against, the problem is the implementation. When it comes to recession analysis, the most blatant problems are in the modelling of household sector behaviour. Since working is voluntary, the hours worked in a period is allegedly a decision variable that can be controlled unilaterally by the household in order to optimise its utility. However, since employment is voluntary — so is unemployment. The result is that recessions can be seen as the optimal decision of households to stop working. As wags have described it, The Great Depression was actually The Great Vacation.

The Great Vacation Effect is a pathological result that few people take seriously. The implication is that it is easy to avoid recessions — tell people to stop cutting back their work hours! However, no matter what one's opinions of politicians are, it is safe to say that no politician would make such a silly suggestion. Even if we put aside the quite obvious criticisms one can make about the silliness of voluntary unemployment, we are stuck with pathological dynamics embedded in the model, hampering recession analysis.

Bond Economics
The Great Vacation: Recessions In DSGE Models (Part I)
Brian Romanchuk