82nd International Atlantic Economic Conference

October 13 - 16, 2016 | Washington, USA

Business cycle shocks as endogenous fluctuations in the estimate of the aggregate technology level

Saturday, October 15, 2016: 2:35 PM
Charles Swanson, Ph.D. , Economics, Temple Univ., Philadelphia, PA
This paper develops and explores a notion of business shocks, one that is related to news shocks, but is not afflicted by a problem common to nearly all of the other candidate shock types, including the by now standard notion of news shocks.  That problem, which was originally invoked to challenge technology shocks, is based on the law of large numbers, and suggests that we would not expect to observe such shocks, nor do we observe them in the real world. 

The model is a generally standard dynamic stochastic general equilibrium model (DSGE) model with the added feature that when a technology advance occurs in one sector, members of other sectors must respond by exerting higher effort levels in order to accommodate that advance, with the number of responding sectors being variable and unobserved. The effect of this feature is to make agents outside of a changing sector unable to determine if a measured productivity increase within a changing sector is due to a technology increase within that sector or to an adoption response by that sector to another sector. The uncertainty continues until the response phase ends.

The result is that the all agents in the economy have an estimate of the aggregate level of uncertainty that has a level of uncertainty that rises and falls through time with the extent of the responding behavior. An end to a response phase will generally bring about a reduction in uncertainty, with the resulting beliefs possibly rising or falling. This change in beliefs is what is called in the paper a business cycle shock. A contraction in uncertainty that is accompanied by a reduction in the estimate of the aggregate technology level will be the driving force of a recession. A contraction in uncertainty that is accompanied by an increased estimate of the aggregate technology level will lead to an economic boom.

The paper links this idea to a number of notions of business cycle shocks, including the original technology shocks (Kydland and Prescott, 1982), the misperceptions idea of Lucas (Lucas, 1972), and the “Risk Shocks” of Christiano, Motto and Rostagno (AER, 2014), where entrepreneurship shocks have widespread effects.  

Keywords: Business cycles, risk shocks, news shocks, technology shocks, growth.