New Keynesian models with unemployment and incomplete markets are rapidly becoming a new workhorse model in macroeconomics. Such models typically require heavy computational methods which may obscure intuition and overlook equilibria. We present a tractable version which can be characterized analytically. Our results highlight that - due the interaction between incomplete markets, sticky prices and endogenous unemployment risk - productivity shocks may have radically different effects than in traditional NK models, that the Taylor principle may fail, and that pessimistic beliefs may be self-fulfilling and move the economy into temporary episodes of low demand and high unemployment, as well as into a long-lasting .unemployment trap.. At the Zero Lower Bound, the presence of endogenous unemployment risk can create inflation and overturn paradoxical properties of the model. We further study financial asset prices and show that non-negligible risk premia emerge.

The ADEMU Working Paper Series is being supported by the European Commission Horizon 2020 European Union funding for Research & Innovation, grant agreement No 649396.