Pricing and Production Without the Invisible Hand -- by Joel P. Flynn, George Nikolakoudis, Karthik Sastry

Modern theories of the business cycle do not allow for the simultaneous rational choice of both prices and quantities, instead assuming that an “invisible hand” determines one of these variables to clear markets. In this paper, we develop a macroeconomic model in which both prices and quantities are chosen optimally by firms and exchange is both voluntary and efficient. As a consequence, individual markets will generically be in Walrasian disequilibrium: either slack (over-supplied) or rationed (under-supplied). The absence of market clearing changes pricing and production in qualitatively important ways: markups are governed by the probability of rationing rather than the elasticity of demand, and higher uncertainty reduces production and increases markups. Marrying the Old and New Keynesian traditions, we study general Walrasian disequilibrium with rational expectations and optimal firm decisions. On a technical level, we characterize cross-market spillovers arising from rationed demand with differentiated goods, overcoming the standard combinatorial problem that arises when studying multi-market disequilibrium. Unlike in New Keynesian economies, monetary shocks propagate by reducing product-market slack, raising aggregate labor productivity and consumption with muted effects on employment, while uncertainty shocks act as stagflationary cost-push shocks.