Recent papers have used shocks to the capital accumulation process to explain the Great Recession of the late 2000s, cf. Gertler and Karadi (2011) and Gertler and Kiyotaki (2011), and the following jobless recovery, cf. Shimer (2010). More generally, a number of authors have suggested that such shocks are important drivers of business cycle fluctuations, cf. Barro (2006, 2009), Gourio (2010), Justiniano, Primiceri and Tambalotti (2010, 2011) and Liu, Waggoner and Zha (2010).
Estimating a series of Dynamic Stochastic General Equilibrium (DSGE) models with regime switches in shock variances and the inflation target, Liu, Waggoner and Zha (2010) find that shocks to the rate of capital depreciation are important sources of both business cycle fluctuations and the shift in the characteristics of fluctuations represented by the Great Moderation. Depreciation shocks have not been much researched, but the result is surprising given the available literature. For instance, a study by Ambler and Paquet (1994) suggests that capital depreciation shocks are largely irrelevant for fluctuations in output and other key macroeconomic variables. In their calibrated Real Business Cycle (RBC) model, capital depreciation shocks are important only because they interact with total factor productivity shocks to improve the model’s implications for the correlation of hours worked and labour productivity, cf. also Duecker, Fischer and Dittmar (2006).
The objective of this paper is twofold. First, the paper seeks to reconcile these two very different sets of results by analysing the propagation mechanism of capital depreciation shocks with emphasis on their potential as important driving forces of business cycle fluctuations. Of particular interest are the conditions under which the shocks generate co-movement of key macroeconomic variables as co-movement is an important feature of empirically recognisable business cycles.
Second, the paper compares the transmission of capital depreciation shocks to quality of capital shocks and investment specific technology shocks. Gertler and Karadi (2011) generate co-movement of hours, consumption, investment and output following a capital quality shock. Similarly, investment-specific technology shocks have been found to be important drivers of the business cycle although they have some difficulties in generating co-movement in particular of consumption, cf. Justiniano, Primiceri and Tambalotti (2010, 2011), Jaimovich and Rebelo (2009) and Furlanetto and Seneca (2010).
To achieve these objectives, we build a New Keynesian DSGE model similar to the model by Liu, Waggoner and Zha (2010). This model nests the RBC model considered by Ambler and Paquet (1994) as a special case without the nominal and real rigidities that are central to the New Keynesian tradition.
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New Perspectives on Depreciation Shocks as a Source of Business Cycle Fluctuations
