Responding to Large and Small Shocks When Business Cycles are Non-Linear

Abstract

The possible presence of non-linear dynamics in macro-systems has become a preoccupation of much recent research in macroeconomics. In this paper we explore some of the empirical issues in the context of a New-Keynesian model with rational expectations in asset markets and nominal inertia in pricing and Wdges. We inject non-linearities into the pricing and investment decisions of firms and explore how this affects the way in which the economy responds to supply and demand shocks of varying magnitude. We find that when the shocks are mild the response to negative and positive shocks is more or less linear. However, when the shocks are large, major asymmetries are triggered. There are significant differences in the response of the economy to shocks of different signs and different sizes. Since the non-linearities we identify in pricing and investment are empirically founded, our results have a number of implications for the conduct of economic policy.