Modern Business Cycle Model with Search Friction

The big picture in this model is that markets do not clear instantaneously to make everyone happy. There are frictions in the labour market. This Diamond, Pissarides model has real unemployment. In RBC models we witness that unemployment is voluntary in nature. This means that if there's a negative productivity shock, then wages might decline and people then would not be willing to work (as long as the substitution effect is greater than the income effect). Basically, a fraction of people doesn't want to work, so RBC (and even NK) can explain the change in unemployment (increase here). However, it can't explain why some people would be unemployed, while some of the similar calibres would be employed. The Search model enables us to explain this (thus real unemployment).


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Note that the notes are based on the lectures of Prof. Wouter den Haan, LSE