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This section will give a detailed description of the household, firm and government sector
as well as their interaction in goods, labour and asset markets. The general philosophy of
the new QUEST model can be characterised as a modern version of the Neoclassical-
Keynesian Synthesis. The behavioural equations in the model are now firmly based on
microeconomic principles of intertemporal optimising behaviour of households and firms
and the supply side of the economy is modelled explicitly via a neo-classical production
function. This feature of the model assures that the long run behaviour of the model
resembles closely the standard neo-classical growth model and the model reaches a steady
state growth path with a growth rate essentially determined by the rate of (exogenous)
technical progress and the growth rate of the population. Also the real rate of interest in the
long run is determined by private savings behaviour, especially the discount rate of private
households. Similarly, the real exchange rate between various countries is fundamentally
determined by demand and supply of domestic and foreign output. This immediately
implies that in this type of model economic policy will not be able to change the long run
growth rate (unless it is able to affect the rate of time preference, the rate of technical
progress or the growth rate of the population). It can however affect the long run level of
output and thereby the growth rate of the economy over extended periods of time until the
new (steady state) income level is reached.
There are two major departures from the neo-classical model in the long run, however.
Because firms are not perfectly competitive but can charge markups over marginal cost in
the long run, the level of economic activity will be lower than that predicted from a model
with perfect competition. Also, the model economy will not reach a steady state equilibrium
with full employment, since we use a bargaining framework to describe the interaction
between firms and workers. As will be described below, labour market rigidities and
therefore involuntary unemployment will persist even in the long run. The short run
behaviour of the model will be influenced by standard Keynesian features since the models
allows for imperfectly flexible wages and prices, adjustment costs for investment and labour
hoarding.
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Households form decisions about consumption and labour supply. In this section we will
discuss consumer behaviour, while labour supply decisions are dealt with in the section on
the labour market. The behaviour of households is characterised by the Life Cycle
Hypothesis as formalised by Blanchard (1984) and Buiter (1988), for example. It is a
generalization of the Permanent Income Model since it allows the analysis of consumption
and saving behaviour of households with possibly only a finite time horizon. This
distinction is at least theoretically important, since depending on the forward looking
horizon of households the consequences of government policies will be treated differently
by households. Ricardian Equivalence for example only holds for infinitely lived
households, while finitely lived households will underestimate the future tax payments
implied from a certain stock of government debt, Lh their discount rate will be higher.
The Life Cycle Hypothesis is an elegant way to model the basically intertemporal savings-
consumption problem of households. According to this hypothesis, households base their