UC Riverside

The standard one-sector real business cycle (RBC, henceforth) model with a constant returns-to-scale technology and perfectly competitive markets and driven solely by news shocks about productivity cannot generate expectations-driven business cycles, i.e., a joint expansion in output, consumption, investment, and hours worked in response to good news about the future.

Our objective is to find the most parsimonious departure from the standard one-sector RBC model able to generate qualitatively and quantitatively realistic business cycle fluctuations driven solely by news shocks about various fundamentals that have high potential in explaining the business cycle volatility.

In chapter 2, we analyze news shocks about productivity. First, we address Eusepi's (2009) analytical finding that a one-sector RBC model may exhibit positive co-movement between consumption and investment when the equilibrium wage-hours locus is positively-sloped and steeper than the household's labor supply curve. First, we show (numerically) that this condition does not imply expectations-driven business cycles will emerge in Eusepi's model, as a positive news shock about future productivity improvement leads to an aggregate recession in which output, consumption, investment, and hours worked all fall in the announcement period. Further, we show that investment adjustment costs may be the element that a one-sector RBC model is missing in order to deliver both qualitatively and quantitatively realistic cyclical fluctuations.

In Chapter 3, we address the importance of news shocks about aggregate demand, such as a preference shock, that may affect the household's marginal utility of consumption. We show that a one-sector RBC model with (i) mild increasing returns-to-scale and (ii) variable capital utilization driven solely by news about preferences can generate qualitatively and quantitatively realistic aggregate fluctuations. In our model economy output, consumption, investment, and hours worked co-move only if the equilibrium wage-hours locus is positively-sloped and its slope is steeper than the slope of the labor supply curve.

In Chapter 4, we address news about income tax rates. We analyze an otherwise standard RBC model, enriched with (i) variable capital utilization and (ii) investment adjustment costs. This framework allows us to isolate the effects of news about labor and capital income tax rates. We find that good news about labor income tax rates cannot generate expectations-driven business cycles, while good news about capital income tax rates can. We calibrate the model to match the observed facts for the U.S economy and simulate a version driven solely by news about capital income tax rates. The model generates not only qualitatively, but also quantitatively realistic cyclical fluctuations.

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