The Role of Correlated Investment-Skill Shocks in Business Cycles

Abstract

In this paper, I study the effects of an exogenous investment shock that is correlated with the skill distribution in the population. In the model, agents, who have heterogeneous productivities, are sorted into different occupations based on their comparative advantages over the business cycle. I also assume that each occupation is associated with a different consumption bundle. This latter assumption implies that as agents switch between low and high-skill jobs their consumption behavior changes in a discrete fashion as well, which in turn gives rise to non-linear income expansion paths at the aggregate level without assuming non-homothetic preferences at the individual level. In this environment, I show that after a positive investment shock, the fraction of agents working in the goods sector increases on impact and those who start working in the goods sector replace their service intensive consumption baskets with goods intensive ones, and therefore the demand for goods increases more relative to the services along the expansion, which in return results in even more agents being hired in the goods sector. I show quantitatively that this endogenous mechanism alone can generate sizable amplification and persistence, even without labor-leisure choice, in contrast to the standard models. The model also suggests an alternative resolution to what is known as the productivity puzzle in the literature. This is because the one-to-one link between output and productivity does not exist in the model, in contrast to the standard models. Instead, the productivity is determined by the aggregate skill distribution and how agents are sorted between two sectors over the business cycle.