NEW CLASSICAL BUSINES CYCLE THOERY:

Yang, Xioaokai,  Economics: New Classical versus Neoclassical Frameworks, Oxford: Blackwell Publishers.  The book goes on to rigorously develop some models and you are encouraged to follow them up. One reason for natural unemployment in a new classical general equilibrium model is changes in the structure of the division of labour. Consider an economy with m consumer goods and n traded goods.  Of these goods, suppose the price of oil rises. The equilibrium values of  m  and  n changes. The demand for luxury sedans, say, might vanish as people stop consuming inessentials. The producers of those goods will be unemployed. They are free to move to sectors which do not face an impact of this exogenous shock. However, since there is  considerable educational capital that has been invested in mastering the nuances of limousine manufacture and the costs of moving are invariably high, these individuals will not be immediately productive as the correspondingly skilled workers in the other sectors. In other words, an economy with a division of labour into specialists will face the phenomenon of unemployment. In fact the two are connected in a relationship: the more elaborate the division of labour, the greater will be the level of unemployment as a response to shocks from without. The situation would not occur in autarky. Since each individual consumes what she produces, any stochastic shocks will be accommodated  by an optimal reallocation across the spectrum of goods consumed.        

Some features distinguish New Classical features of business cycles from other forms of business cycle. The extent of  the division of labour and the level of specialisation for each individual are grounded in dynamic microeconomic choices. The model generates persistent, regular, endogenous, and efficient business cycles. It also simultaneously generates endogenous, and efficient, unemployment.  The model is consistent with empirical phenomena like the fact that the output of durables fluctuates more than the output of nondurables.     One insight is that the business cycle is inextricably linked with trade and financial openness. In its modern form it is exemplified in developed economies with a complex division of labour and high productivity. Let us consider an economy that consists of many agents. Each individual can produce a perishable good called corn and a durable good called tractors. A tractor is indivisible and each driver can drive only one tractor as a capital input in the production of food at any point of time. Each job is skill-specific and two types of cost will be incurred if an individual shifts between activities. There is obsolescence of knowledge and memories will decay when an individual moves from one activity to the other. There is also an entry cost, a nontrivial investment in education that an individual has to incur before she enters any activity. A tractor has a life of two years. Each individual's utility function is defined over consumption (food) and the objective is to maximise the present value of total utility.         

At least three possible equilibrium situations follow. The first is autarky. Each individual divides her time between manufacturing a tractor and using it to produce food in the first year, and produces only food in the second year. This structure is cycle-free. Yet, such an economy cannot garner Smithian gains from the division of labour. The second structure is one in which the division of labour is fully accomplished. The population is divided between producers of food and producers of  capital goods. In each year, professionals drive tractors to produce food. Theproducers of tractors manufacture them in  the first year and are unemployed in thenext. Total output in the first year is higher than the second. Thus, we see a businesscycle of two years with unemployment in the second year. Learning by doing ismaximal here and the society is best poised for the accumulation of human capital.The third structure is partial division of  labour. Here, producers of tractors move tothe production of food in the second year. Thus, farmers are completely specialisedand can reap those economies whereas producers of tractors are not.