Business cycles and business cycle shocks

This paper first reviews the set of sources of shocks that have been put forth as possible sources of business cycle fluctuations, and argues that two of the primary objections once levied against technology shocks also apply to most of these other shocks as well. The objections against technology shocks were first that because of the law of large numbers we would not expect to see simultaneous, economy-wide technology movements, and second, at the magnitude required to drive business cycles, we do not actually see such movements in the real world. The first part of the paper argues that to the extent that this argument applies to technology shocks, it also applies to most of the other proposed shocks as well, including most types of preference shocks, demand shocks, as well as news shocks and uncertainty shocks. The data sources used are from the Bureau of Economic Analysis and the Bureau of Labor Statistics.

The second part of the paper develops the properties of a class of shocks that will not be subjected to this law of large numbers objection. The set of properties in this class includes a prominent aggregate variable (such as a technology level), a reason for uncertainty about it, and a reason for that uncertainty to fluctuate endogenously through time.

The third part of the paper presents a dynamic stochastic general equilibrium (DSGE) model that satisfies the required properties of this class of shocks. The model has an aggregate technology level that has a dominant role in determining aggregate variables such as consumption, investment and labor. The level of that technology variable is not directly observed, but is rather estimated by all participants. The distinctive part of the model is that each of a large number of sectors have their own technology and effort levels. That effort rises when technology adoption occurs and elevated levels of effort mask technology changes in the sector with the elevated effort. Thus, the feature that has made estimation of the current technology level so difficult for econometricians observing the economy is also of central importance for participants in the economy. It forms the key ingredient in explaining the business cycle source.