Building Blocks of Market Clearing Business Cycle Models

Abstract

We compare "real business cycle" and increasing returns models of economic fluctuations. In these models, business cycles are driven by productivity changes resulting either from technology shocks or from movements along the increasing returns production function. We stress four crucial building blocks that give both types of models hope of fitting the data. These building blocks include durability of goods, specialized labor, imperfect credit and elastic labor supply. We also present new evidence on co-movement of both outputs and labor inputs across sectors and on the behavior of relative prices over the business cycle. We conclude that the increasing returns model is easier to reconcile with the data than the real business cycle model.