Ebook Anticipated Growth and Business Cycles in Matching Models
Economists have long recognized the importance of expectations in explaining economic fluctuations. As early as 1927, Pigou postulated that ”the varying expectations of business men ... constitute the immediate cause and direct causes or antecedents of industrial fluctuations.” A recent episode where many academic and non-academic observers attribute a key role to expectations is the economic expansion of the 1990s. During the 1990s, economic agents observed an increase in current productivity levels, but also became more optimistic regarding future growth rates of productivity. In fact, there was a strong sense of moving towards a new era, the ”new economy”, of higher average productivity growth rates for the foreseeable future. With the benefit of hindsight it is easy to characterize the optimism about future growth rates as ”unrealistic”. At the time, however, the signals about future productivity were in fact remarkable, and the view that a new era was about to begin was shared by many experts, including economic policy makers such as Alan Greenspan. Similarly, the question arises whether the downward adjustment of these high expectations about future growth rates did not at least magnify, if not cause, the economic downturn that took place at the beginning of the new millennium.
More formal empirical evidence that business cycles are caused by anticipated changes in future productivity is provided by Beaudry and Portier (2005a). They use changes in stock prices to identify that fraction of future changes in productivity that is anticipated, and argue that this fraction is actually quite large. They show that innovations in technology are small but initiate substantial future increases in productivity. Moreover, this expectation shock leads to a boom in output, consumption, investment, and hours worked before the anticipated productivity growth actually materializes.
Beaudry and Portier (2005b) analyze whether existing neo-classical models can generate Pigou cycles. In a Pigou cycle, output, consumption, investment, and hours worked jointly increase in response to an anticipated increase in productivity and these variables decline when the anticipated increase fails to materialize. They consider a large class of models and show that the answer is no. Instead, the typical response is an increase in consumption but a decrease in investment and hours worked. The reason is that the wealth effect induces agents to increase consumption and leisure. It is not difficult to generate an increase in investment, because the anticipated increase in productivity also causes the expected return on capital to go up. The problem is, however, that higher levels of investment are typically financed by a reduction in consumption, not by an increase in hours worked. The real challenge is therefore to build a model in which hours worked increase in response to anticipated productivity growth.
Perhaps, it should not come as a surprise that an anticipated increase in productivity does not lead quite naturally to a boom in existing models. In most business cycle models, aggregate productivity is an exogenous process, and agents get the increase in productivity ”for free”. As a result, the aggregate economy behaves the way an individual agent behaves if he finds out about a windfall to be received in the near future. He goes on a spending spree (i.e., consumption increases), takes a vacation (i.e., employment decreases), and finances this indulgence by dissaving (i.e., investment decreases).
Recently, some models have been developed where an increase in expected productivity generates a business cycle boom even though productivity improvements still fall like manna from heaven. Exemplary papers are Beaudry and Portier (2004), Beaudry and Portier (2005b), Christiano, Motto, and Rostagno (2006), and Jaimovich and Rebelo (2006). In Beaudry and Portier (2004), Beaudry and Portier (2005b), and Jaimovich and Rebelo (2006), the positive co-movement of investment and consumption is generated by making it too costly for variables to move in the ”wrong” direction. This can be accomplished by complementarities in the production technology or particular forms of capital adjustment costs. Christiano, Motto, and Rostagno (2006) assume that nominal wages are sticky and show that this implies an expansionary monetary policy when expected future productivity increases. The reason is that the increase in the real wage caused by the expansion brings about a reduction in inflation when nominal wages are sticky. The reduction in inflation in turn leads to a reduction in interest rates when the central bank follows a Taylor rule.
In this paper, we approach the challenge to build a model that can generate Pigou cycles from a different angle. The key idea is that increases in aggregate productivity are not free, at least not to everybody, and that in order to benefit from the anticipated increase in productivity agents have to invest resources. To show the strength of this argument, we build a model in which the productivity process is still exogenous, and an increase in productivity is free to everybody already engaged in productive activities. The increase in productivity does not come for free, however, to firms and workers that are not already engaged in market production. Instead, forming a productive relationship takes time and requires resources. As a result, firms start investing in new projects immediately and do not delay looking for additional workers when expected productivity growth increases. Similarly, there is an incentive for workers to enter the labor force as soon as expectations about future productivity increase. As employment increases, consumption and investment can increase before actual productivity goes up.
In particular, we incorporate a standard labor market matching framework into a real business cycle (RBC) model. The labor market matching model is becoming (or is) the benchmark model to explain fluctuations in aggregate employment. Because of the matching friction it is well suited to model the idea that not everybody automatically benefits from productivity increases. To see whether this model can generate Pigou cycles, we study the transition from a low-growth-low-expectations regime to a low-growth-high-expectations regime. This transition does not affect actual productivity, but it does affect the probability of switching to a regime with high productivity growth rates. Expected future productivity, thus, increases. We will show that this increase in expected productivity generates an economic expansion even though productivity levels themselves have not yet gone up.
In the standard matching framework, the mass of workers that is either employed or searching for a job, that is, the total labor force, is fixed. In contrast, in the standard RBC model, labor supply is determined by a labor/leisure decision. An anticipated productivity increase then generates a reduction in employment, because the wealth effect increases the demand for leisure. The standard matching model–by keeping the mass of potential workers fixed–does not allow for this channel to operate and consequently makes it easier to generate Pigou cycles. We show, however, that the model can still generate Pigou cycles if we allow the wealth effect to affect labor supply just as in standard RBC models.
In our model, just as in the standard RBC model, the wealth effect associated with an increase in expected productivity growth has a downward effect on labor supply. Never-theless, labor supply only displays a very modest decline in our framework. The reason is that–because of the matching friction–the increase in the expected productivity growth rate increases the benefits for workers of being in a productive relationship, just like it increases the benefits for firms. Due to the higher number of vacancies being posted, the small decrease in the labor force goes together with an increase in the employment rate and a reduction in the unemployment rate.
The paper is structured as follows. In Section 2 we discuss the model. In Section 3, we discuss standard summary statistics and we explain why our model generates a countercyclical unemployment rate, whereas other models with endogenous labor force participation do not. In Section 4, we document that the model can generate a typical expansion in response to an increase in the anticipated productivity growth rate. The last section concludes.
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