Long-run growth uncertainty

Abstract

Observed macroeconomic forecasts display a positive correlation between expectations of long-run growth of endogenous variables (e.g., output) and cyclical activity. Existing business cycle models appear inconsistent with the evidence. This paper presents a model of the business cycle in which households have imperfect knowledge of long-run growth rate of endogenous variables and continually learn about these growth rates. The model features comovement and mutual influence between households׳ growth expectations and market outcomes. It can replicate the evidence on growth forecasts and suggests that optimism and pessimism about long-run growth rates is a crucial ingredient in understanding business cycle fluctuations.