Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

News Shocks and Business Cycles

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

News Shocks and Business Cycles

Article excerpt

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The discussion surrounding the recent deep recession seems to have shifted the focus from currently used business cycle models to the standard Keynesian model (by which we mean the "old Keynesian," as opposed to the newKeynesian, model). In theKeynesian model, pessimism among consumers and investors about the economy will simultaneously lower aggregate consumption and aggregate investment, as well as aggregate output, through an increase in the rate of unemployment, and more generally through lower capacity utilization. Moreover, in the Keynesian model, pessimism and optimism are not determined within the model-they appear exogenously and they disappear exogenously. The analysis is then about how the economy reacts to these exogenous events. Undoubtedly, there are many indications that consumers and investors seemed pessimistic about their prospects during the recession, but does such pessimism necessitate the reversion back to the Keynesian model? The present article reviews and contributes to a recent strand of the "modern" business cycle literature, i.e., the literature that insists on building a model of the economy that is explicit about its microeconomic foundations and that addresses a related question: Can news shocks generate positive co-movement among our macroeconomic aggregates? An example of a negative news shock would be the sudden arrival of information indicating that future productivity will not be as high as previously thought. Thus, such a shock would generate current pessimism, and yet be grounded in real and fundamental developments. Another kind of news shock would be a government announcement about a policy change to be implemented on a future date (say, that taxes will be raised beginning next year). In this recent literature, thus, optimism and pessimism are examined as determinants of business cycle fluctuations, but as add-ons to otherwise microfounded macroeconomic models, and moreover they are tied in a systematic way to anticipated changes in the economy's fundamentals.

Models of business cycles that rely on microeconomic foundations generate fluctuations in economic activity in response to fluctuations in fundamentals, such as preferences, technology, or government policy. The first generations of these models (Kydland and Prescott 1982) relied on technology shocks, i.e., shocks to aggregate productivity; such a shock, if positive and persistent, would raise output directly, via an increase in aggregate employment, and as a consequence raise both consumption and investment, thus generating the kind of co-movement we observe in aggregate time series. Shocks to government expenditures have been considered as well, as have preference shocks (for consumption now versus consumption in the future), though these shocks alone do not easily generate co-movement in the remaining aggregate variables. For example, when government spending rises there is strong pressure on either consumption or investment to fall, unless hours worked (or perhaps capital utilization) rises significantly; hours worked might increase if there is a significant wealth effect in labor supply, but in standard parameterizations the wealth effects are not strong enough.

The new literature begins with Beaudry and Portier (2006, 2007), who analyze time-series data and conclude that news about future productivity may be an important driver of business cycles and then go on to discuss in what model economies news can generate co-movement. We briefly reviewthe data analysis in Section 1. In Section 2, we explain why news shocks, like some other shocks, do not readily generate co-movement in standard neoclassical settings. Beaudry and Portier suggest their own setting, wherein news shocks have the desired effect, but there are other frameworks that generate co-movement in response to news shocks as well. Section 3 describes a very simple setting that we think has most, if not all, of the necessary qualitative effects: the Pissarides (1985) model. …

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