A Business Cycle Model Based on Efficiency Wages, Monopolistic Competition and Nondecreasing Returns

A model is analyzed in which workers' efforts depend positively on the real wage and the unemployment rate. Due to isoelastic demand and constant marginal cost it is optimal for firms to set the output price as a fixed markup over the nominal wage. When demand shocks occur, firms' first response is therefore to adjust output and employment. But as the unemployment rate changes, the efficient real wage changes too. This causes firms to adjust their nominal wages and prices which in turn implies a revision of labour input and goods input. The resulting dynamics is capable of generating counterclockwise movements in the output-inflation-plane. This is illustrated in an example in which size and length of the business cycle depend on the responsiveness of effort to changes in the unemployment rate.