Indeterminacy, aggregate demand, and the real business cycle

We show that under indeterminacy aggregate demand shocks are able to explain not only aspects of actual fluctuations that standard RBC models predict fairly well, but also aspects of actual fluctuations that standard RBC models cannot explain, such as the hump-shaped, trend reverting impulse responses to transitory shocks found in US output (Cogley and Nason, Am. Econom. Rev. 85 (1995) 492); the large forecastable movements and comovements of output, consumption and hours (Rotemberg and Woodford, Am. Econom. Rev. 86 (1996) 71); and the fact that consumption appears to lead output and investment over the business cycle. Indeterminacy arises in our model due to capacity utilization and mild increasing returns to scale.     

Monetary policy, taxes, and the business cycle

This paper analyzes the interaction of inflation with the tax code and its contribution to aggregate fluctuations. We find significant effects operating through the tax on realized nominal capital gains. A tax on nominal bond income magnifies these effects. Our innovation is to combine monetary policy shocks with non-indexed taxes in a model where the central bank implements policy using an interest rate rule. Monetary policy had important effects on the behavior of the business cycle before 1980 because policymakers did not exert effective control over inflation. Monetary policy reform around 1980 led to better control, and with more stable inflation, the effect of the interaction between monetary policy and the nominal capital gains tax has become negligible.     

Unemployment and the business cycle

This paper presents a dynamic general equilibrium model where labor effort is imperfectly observable and there is unemployment in equilibrium. In contrast to shirking models in the efficiency wage literature, detected shirkers are not dismissed. Instead, they face a monetary punishment because they forgo an increase in their compensation. Estimated versions of the model can generate the high variation in employment and low variation of real wages observed over the business cycle, and are consistent with existing qualitative evidence about the responses of the economy to fiscal policy shocks.     

Comparing New Keynesian models of the business cycle: A Bayesian approach

The baseline New Keynesian model cannot replicate the observed persistence in inflation, output, and real wages for sensible parameter values. As a result, several extensions have been suggested to improve its fit to the data. We use a Bayesian approach to estimate and compare the baseline sticky price model of Calvo's [1983. Staggered prices in a utility maximizing framework. Journal of Monetary Economics 12, 383-398.] and three extensions. Our empirical results are as follows. First, we find that adding price indexation improves the fit of Calvo's [1983. Staggered prices in a utility maximizing framework. Journal of Monetary Economics 12, 383-398.] model. Second, models with both staggered price and wage setting dominate models with only price rigidities. Third, introducing wage indexation does not significantly improve the fit. Fourth, all model estimates suggest a high degree of price stickiness. Fifth, the estimates of labor supply elasticity are higher in models with both staggered price and wage contracts. Finally, the estimated inflation parameters of the Taylor rule are stable across models.     

Managerial incentives,capital reallocation,and the business cycle

We argue that when managers have private information about the productivity of assets under their control and receive private benefits, substantial bonuses are required to induce less productive managers to declare that capital should be reallocated. The need to provide incentives for managers to relinquish control links executive compensation to capital reallocation and managerial turnover over the business cycle, rendering them procyclical if expected managerial compensation increases when more managers are hired. Moreover, capital is less productively deployed in downturns because agency costs make reallocation more costly. Empirically, we find that both CEO turnover and executive compensation are remarkably procyclical.     

Entrepreneurial activity, risk, and the business cycle

This paper analyzes a model in which the risk associated with entrepreneurial activity implies that the amount of such activity is procyclical and results in amplification and intertemporal propagation of productivity shocks. In the model risk averse agents choose between a riskless project and a risky project with higher expected output (‘the entrepreneurial activity’). Agents who become entrepreneurs need to bear part of the project-specific risk for incentive reasons. More agents become entrepreneurs when productivity is high, because agents are more willing to bear risk and need to bear less risk for incentive reasons. Furthermore, cross-sectional heterogeneity can be countercyclical.     

Firm Microstructure and Aggregate Productivity

Models of firm microstructure are becoming now a standard building block in macroeconomics, trade, and development. This literature builds on the recognition that firm heterogeneity and the allocation of resources across firms plays a key role in determining aggregate productivity and the gains from trade. Barriers to the efficient allocation of resources across firms have been recently recognized to play a key role in economic development. This paper focuses on this methodological contribution, the link between firm microstructure and economic aggregates.     

Price and Investment Dynamics: Theory and Plant-Level Data

We construct a model of a firm competing for market share in a customer market and making investments in physical capital. The firm is financially constrained and there are implementation lags in investment. Our model predicts that product prices should depend on costs and competitors' prices but respond weakly to demand shocks. Also, prices should be strongly related to investment. We estimate price and investment equations on panel data for Swedish manufacturing plants and find results that are qualitatively in line with these predictions, though the relation between investment and prices is stronger than predicted by our model.     

Free entry and business cycles under the influence of animal spirits

We provide a business cycle model in which endogenous markup fluctuations are the main driving force. These fluctuations occur due to some form of ‘animal spirits’, impelling firms in their entry-exit decisions within each sector. By contrast to existing models of the business cycle emphasizing the role of animal spirits, we do not rely on the sink property of the equilibrium to generate indeterminacy. Hence, while our model does pretty well in accounting for the main features of US business cycles, it avoids several criticisms addressed to these former models, concerning either their dependence upon strongly increasing returns, too high markups, or their implication of countercyclical movements of consumption.     

Cross-sectional heterogeneity and the persistence of aggregate fluctuations

The microevidence indicates that small firms grow faster than big firms. I argue that this relationship between the expected growth rate of a firm and its size may provide a microfoundation for the well-known high degree of persistence of shocks to aggregate output. The logic goes as follows. Almost any shock tends to temporarily alter firms' incentive to invest in growth thereby leading to a reallocation of firms across size categories. If small firms grow faster than big ones, the impact effect of the shock on aggregate output is gradually absorbed. But, as fast growing small firms become big and start to grow at the lower rate of big firms, the rate at which the shock is absorbed decreases over the adjustment path. As a result, shocks are absorbed, yet at a very low decreasing rate which induces long memory in aggregate output. I argue that this transmission mechanism may reconcile the microevidence with the observed degree of aggregate persistence. It requires changes in neither the number of firms in the market nor the rate of technological progress. It is merely the result of the cross-sectional heterogeneity that we observe in real economies.     

Do long swings in the business cycle lead to strong persistence in output?

This paper investigates how the occasional long swing in the business cycle can produce long-memory behavior in US output. To prove this theoretical relationship, we extend the Hamilton Markov chain regime switching model of real aggregate output to include the occasional long regime. We do this by modeling the duration length of the expansion and recession regimes as draws from a fat-tailed distribution with realized durations that are high in variability and occasionally extreme in value. Empirically, we find that the tail indices for the length of US economic booms and busts correspond with the long-memory parameter estimates of Diebold and Rudebusch [1989. Long memory and persistence in aggregate output. Journal of Monetary Economics 24, 189-209] and Sowell [1992a. Modeling long-run behavior with the fractional ARIMA model. Journal of Monetary Economics 29, 277-302] for real US output. Estimates of our extended regime switching model produce better short- and long-run forecasts of output in comparison to forecasts with a fractionally integrated model. Furthermore, our estimated regime-switching model finds US expansions to be fragile during their infancy, but become more and more likely to continue after surviving the first seven quarters.     

The influence of product market dynamics on a firm's cash holdings and hedging behavior

Prior work suggests that if a firm shares a larger proportion of its growth opportunities with rivals, an inability to fully invest in these opportunities leads to predatory behavior on the part of rivals and losses in market share. We examine whether firms manage this predation risk. We find inter- and intra-industry evidence that the extent of the interdependence of a firm's investment opportunities with rivals is positively associated with its use of derivatives and the size of its cash holdings. Moreover, an analysis of investment behavior provides evidence that if this interdependence is high, the management of predation risk provides strategic benefits. Our results indicate that predation risk is an important determinant of corporate financial policy choices and investment behavior.     

Financial shocks and the US business cycle

Employing the financial accelerator (FA) model of Bernanke et al. [1999. The Financial accelerator in a quantitative business cycle framework. In: Taylor, J.B., Woodford, M. (Eds.), Handbook of Macroeconomics, vol. 1C. Handbooks in Economics, vol. 15. Elsevier, Amsterdam, pp. 1341-1393] enhanced to include a shock to the FA mechanism, we construct and study shocks to the efficiency of the financial sector during post-war US business cycles. These shocks are found to (i) be very tightly linked with the onset of recessions, more so than TFP or monetary shocks; (ii) remain contractionary after recessions have ended; (iii) account for a large part of the variance of GDP; (iv) be generally much more important than money shocks and (v) be strongly negatively correlated with the external finance premium.     

The scarring effect of recessions

According to the conventional view, recessions improve resource allocation by driving out less productive firms. This paper posits an additional scarring effect: recessions impede the developments of potentially superior firms by destroying them during their infancy. A model is developed to capture both the cleansing and the scarring effects. A key ingredient of the model is that idiosyncratic productivity is not directly observable, but can be learned over time. When calibrated with statistics on entry, exit and productivity differentials, the model suggests that the scarring effect dominates the cleansing effect, and gives rise to lower average productivity during recessions.     

Understanding the inventory cycle

Careful examination of aggregate data from the U.S. and other OECD countries reveals that production and inventory behavior exhibit paradoxical features: (1) Inventory investment is strongly countercyclical at very high frequencies (e.g., 2-3 quarters per cycle); it is procyclical only at relatively low-cyclical frequencies such as the business-cycle frequencies (e.g., 8-40 quarters per cycle). (2) Production is less volatile than sales around the high frequencies; it is more volatile than sales only around business-cycle or lower frequencies. (3) Unlike capital investment or GDP, the bulk of the variance of inventory investment is concentrated around high frequencies rather than around business-cycle frequencies. These features of production and inventory behavior at the low and high frequencies provide a litmus test for inventory theories. This paper shows that the stockout-avoidance theory [Kahn, J., 1987. Inventories and the volatility of production. American Economic Review 77, 667-679.] has much better potential than other competing theories for explaining the seemingly paradoxical features of inventory fluctuations observed at different cyclical frequencies. My analysis suggests that demand shocks are the main source of the business cycle.     

The Firm Size Effect and the Economic Cycle

Small firms have, on average, lower return on assets and higher leverage than do large firms. Small firms tend to do well in good economic conditions but to perform poorly in the worst economic conditions. We investigate the hypothesis that the small firm effect is manifest in the expansion phase of the economic cycle but not in the contraction phase. The empirical results of our study confirm the hypothesis for 1976–95. We use the alpha, residual, and regression methods in testing the hypothesis.     

Instability of sunspot equilibria in real business cycle models under adaptive learning

We provide conditions under which a general, reduced-form class of real business cycle (RBC) models has rational expectations equilibria that are both indeterminate and stable under adaptive learning. Indeterminacy of equilibrium allows for the possibility that non-fundamental “sunspot” variable realizations can be used to drive the model, and several researchers have offered calibrated structural models where sunspot shocks play such a role. However, we show that the structural restrictions researchers have adopted lead to reduced-form systems that are always unstable under adaptive learning dynamics, thus calling into question the plausibility of these sunspot-driven RBC models.     

Finance,Firm Size,and Growth

Although research shows that financial development accelerates aggregate economic growth, economists have not resolved conflicting theoretical predictions and ongoing policy disputes about the cross‐firm distributional effects of financial development. Using cross‐industry, cross‐country data, the results are consistent with the view that financial development exerts a disproportionately positive effect on small firms. These results have implications for understanding the political economy of financial sector reform.     

Financing constraints, irreversibility, and investment dynamics

We develop a model of an industry with many heterogeneous firms that face both financing constraints and irreversibility constraints. We use this model to examine the cyclical behavior of aggregate fixed investment, variable capital investment, and output in the presence of persistent idiosyncratic and aggregate shocks. Our model yields three main results. First, the effect of the irreversibility constraint on fixed capital investment is reinforced by the financing constraint. Second, the effect of the financing constraint on variable capital investment is reinforced by the irreversibility constraint. Finally, the interaction between the two constraints is key for explaining why input inventories and material deliveries of US manufacturing firms are so volatile and procyclical, and also why they are highly asymmetrical over the business cycle.     

Organizational capital, technology adoption and the productivity slowdown

There is evidence linking the productivity slowdown of the 1970s and 1980s to changing patterns of technological adoption related to the spread of information technology (IT). Notably, IT appears to require plant-level reorganization for its full implementation.I develop a general equilibrium model in which organizational capital plays a central role in establishment dynamics, and study its transition path after a shock in the form of an incompatibility between new technologies and previously accumulated plant-level expertise. The behavior of the model is consistent with the structure of the slowdown, as well as the subsequent resurgence. Further applications are discussed.