We develop a two-sector general equilibrium model in which equilibrium unemployment arises endogenously because of trading frictions in the labor market of one sector. Externalities inherent in the search process lead to inefficient equilibria, and this has important implication for the basic structure of the economy. In particular, the relationship between factor rewards and commodity prices is fundamentally different from the analogous relationship in a frictionless economy. One implication is that the economy's relative supply curve may be downward sloping, especially when the search sector is small. We also present several applications of the analysis.

We argue that the government-spending multiplier can be much larger than one when the zero lower bound on the nominal interest rate binds. The larger is the fraction of government spending that occurs while the nominal interest rate is zero, the larger is the value of the multiplier. After providing intuition for these results, we investigate the size of the multiplier in a dynamic, stochastic, general equilibrium model. In this model the multiplier e�ect is substantially larger than one when the zero bound binds. Our model is consistent with the behavior of key macro aggregates during the recent financial crisis. We thank the editor, Monika Piazzesi, Rob Shimer, and two anonymous referees for their

We develop a two-sector general equilibrium model in which equilibrium unemployment arises endogenously because of trading frictions in the labor market of one sector. Externalities inherent in the search process lead to inefficient equilibria, and this has important implication for the basic structure of the economy. In particular, the relationship between factor rewards and commodity prices is fundamentally different from the analogous relationship in a frictionless economy. One implication is that the economy's relative supply curve may be downward sloping, especially when the search sector is small. We also present several applications of the analysis.