Business cycle shocks

Explanations for the source of business cycles have evolved substantially since 1982, when the first DSGE paper was published by Kydland and Prescott. The currently most prominent view is that there is a set of driving shocks, including technology, preference and monetary shocks.

Difficulties with each of these has led to the notion of “News shocks,” whereby large and abrupt changes occur with respect to information about aggregate variables. This paper provides an environment in which such information flows might arise endogenously. The main idea is that technology evolves smoothly along a path with non-constant growth. The current aggregate level is not known at any given time, but is being continually re-estimated by all market participants.

The model contains a dispersed set of sectors, each with their own technology level. When some sectors experience a technology improvement, there is a second set of sectors that must respond to this improvement by either exerting more work effort or work time to adopt or accommodate the new technology. This response prevents outsiders from accurately observing whether the responding sector itself has experienced a technology improvement. When the response period ends, technology growth within the responding sector is revealed.

Irregular sizes in the response groups causes fluctuations in the degree of uncertainty regarding the aggregate level of technology. When the response group shrinks, there is an increase in the precision with which the technology is estimated. This increase is what I call a driving shock. The increase in precision can lead to an increase or a decrease in the estimate of the level of the technology, and thus to both a rise or a fall in GDP.

Many of the difficulties of the news shocks literature arise in the current paper for many of the same reasons. The most prominent solutions to the those difficulties, especially the learning-by-doing idea proposed recently, are essential elements of the dynamics of the model itself.