Can News about the Future Drive the

Business Cycle?
- Nir Jaimovich & Sergio Rebelo
Jarrod Brodsky, Nam Nguyen, Jin Wang
Advanced Topics in Modern Macroeconomics
May 1
st
2014
Outline
1. Motivation
2. Introduction
3. The Model
4. Model Simulations
5. Conclusion
Motivation
In the observed data, there is comovement in
aggregate variables (aggregate comovement):
Output (Y)
Consumption (C)
Investment (I)
Labor hours (N)
Real Wages (W)
Jaimovich and Rebelo postulate that good news about
the future translates to an increase in these aggregate
variables today. This can be observed in the data.
Introduction
Key Questions:
What types of news shocks drive the comovement?
Can such news shocks create realistic business cycles?
Jaimovich and Rebelo consider the effects of news about future
productivity shocks and investment shocks
Productivity shocks affect the production function
Investment specific shocks affect the allocation between
consumption and planned investment
Problem: with standard preferences and technology good news
about the future makes people slack off today.
Solution: introduce a series of modifications to generate
comovements
3 Modifications that Generate the Comovements
1. Class of preferences that embed GHH on one side and KPR on the other
GHH: zero wealth effect and positive substitution effect on labor
Increase in lifetime wages causes increase in hours worked (N
t
)
KPR: negative wealth effect and positive substitution effect on labor
Overall effect of a lifetime increase in wages is weak on labor supply
2. Variable Capital Utilization (u
t
)
Increase the utilization of current capital stock to increase output today in
response to good news about the future
Increase in demand for labor which will increase wages today
3. Investment Adjustment Cost ()
Increase in u
t
causes faster capital depreciation [(u
t
)] and require more
investments to replenish capital stock (K
t
)
An adjustment cost is incurred every time when there is a change in the overall
level of investment ratio (
I
t
I
t-1
)
Provides incentives to start investing today to smooth out response of
investment
The Model Preferences
U = Lifetime Utility; C
t
= Consumption; N
t
= Hours Worked; X
t
= factor that amplifies disutility of
labor due to past and current cons. choices
u = E
0

[
t
C
t
N
t
0
X
t
1-c
1
1 o

t=0
X
t
= C
t
y
X
t-1
1-y
Case 1: y = CHH
Intratemporal choice between labor hours and consumption:
MRS between labor and consumption = 0X

N
t
0-1
= w
t
N
t
=
w
t
0X

^(
1
0-1
)
Observations:
Zero lifetime wealth effect
Elasticity of labor supply depends on 0
As a result, hours worked are permanently higher after good news arrives
Case 2: (y = 1) KPR
Strong negative wealth effect on hours worked, implying that labor
supply is inelastic
Observations:
an increase in lifetime wages implies a weak effect on N
t
no comovement with KPR preferences between good news and
hour worked
Case 3: < y < 1 GHH and KPR
In short run response is similar to GHH, in long run response of
hours worked looks like KPR
Observation:
strong short run positive comovement between hours worked and
good news
The Model Preferences Contd
The Model Technological Constraints
z
t
: investment specific technology shock

t
= A
t
u
t
K
t
1-u
N
t
u
A
t
: Total Factor Productivity; u
t
: Capital utilization rate; N
t
: hours worked; K
t
: stock of capital
K
t+1
= |1 u
t
]K
t
+I
t
|1
I
t
I
t-1
]
o u
t
: deprecation in the rate of utilization;
I
t
I
t-1
: percentage of investment wasted
Assumptions:
No adjustment cost in the steady state
Depreciation is convex in the rate of utilization (firms choose to smooth out investments)
Adjustment costs are convex in (
I
t
I
t-1
)

t
= C
t
+
I
t
z
t
Equilibrium Response to A
t
and z
t
Shocks
A
t
or z
t
hits the economy
Expect I
t
to rise at t=3
Firms want to increase investment at t=1 due to the effects from adjustment cost
Value of capital at t=1 decreases; capital is less costly which leads to actual increase in
investment and capital utilization
As u
t
increases, MPL increases, which leads to higher demand for labor, generating
comovement with output
Wage increases and hours worked increases (substitution effect outweighs income effect)
The Model Response to News Shock
(Percentage deviation from steady state)
Business Cycle Simulation
(with investment-specific technical progress)
Purpose:
To test if the model is able to generate empirically recognizable business fluctuations (i.e.
volatility, comovement, and persistence of macroeconomic aggregates)
Process:
Simulating a version of the model driven by stochastic, investment-specific technological
progress (z
t
) and compute the standard set of business statistics
Assuming log(z
t
) follows a random walk: log(z
t+1
) = log(z
t
) +
t+1
Z
t
is measured using quarterly data on US real price of investment from 1947 to 2004
Key Findings:
1. The cycle moments are similar to those of postwar US data
2. Consumptions, investment and hours worked are procyclical
3. Providing economy with news does not alter the patterns or relative size of indicators
4. Advances in information technology accounts for volatility decline and persistence
increase
5. Recessions are driven by bad news about the future, not shocks today
Conclusion
1. Introducing these modifications leads to aggregate
comovements due to positive news about the future
2. The model can also be calibrated to create realistic
business cycles in the data
3. In general, these results suggest that good news
about the future can be an important determinant in
business cycle