The Economics of the Treasury Model
The Treasury model, in common with most other current UK macro models, is based on theories of imperfect competition. Its properties can be characterised as Keynesian in the short run but with a neo-classical long run equilibrium.
In the short run, the demand side of the economy determines the level of output. Conventional downward sloping demand curves in both goods and labour markets dictate the quantity of output produced and labour employed. The level of wages comes from bargaining between firms and unions. This in turn feeds through to prices which are a mark-up on marginal costs. An important feature of the model is 'stickiness' between wages and prices. Contractual arrangements, adjustment costs and generally slow adjustment processes ensure that the labour market takes some time to reach equilibrium following any external shock. The period of disequilibrium is reflected by movements in aggregate demand and hence unemployment away from 'normal' levels.
The long-run properties of the model are derived from the supply side. The natural rate of unemployment in the model is determined by the interaction of wages and prices. The NAIRU does not depend on price level or the rate of inflation and therefore there is no long run trade off between unemployment and inflation. The sustainable level of output reflects this natural rate of unemployment. In the very long run the model is neo-classical. The underlying growth rate of the economy is determined by the productivity growth rate and also by the growth of the working population.