Comovement Problem Research Articles

Investment Shocks: The Labour Wedge and the Comovement Problem

Investment Shocks: The Labour Wedge and the Comovement Problem

Tax Evasion, Investment Shocks, and the Consumption Puzzle: A DSGE Analysis with Financial Frictions

AbstractRecent studies identify Marginal Efficiency of Investment (MEI) shocks as important drivers of the business cycle. However, Dynamic Stochastic General Equilibrium (DSGE) models struggle to explain macroeconomic comovements between consumption and the key real variables after a MEI shock. Moreover, engaging in tax evasion practices is often an answer to financial constraints, which have been recognized as important determinants of cyclical fluctuations as well. We use a medium‐scale New Keynesian DSGE model, that combines tax evasion with financial frictions, to simulate a MEI shock. We show that entrepreneurial tax evasion can solve the comovement problem to a fair extent.

Durable Goods, Investment Shocks, and the Comovement Problem

AbstractSticky‐price models suggest that capital investment shocks are an important driver of business cycle fluctuations. Despite quantitative importance in explaining business cycles, a comovement problem emerges because the shocks generate intertemporal substitution effects away from consumption toward investment. This paper resolves the problem by extending the standard sticky‐price model to a two‐sector model with consumer durable services. When durable goods are used as investment in capital and consumer durables, positive capital investment shocks also generate intratemporal substitution effects away from consumer durable services toward nondurable consumption that dominates intertemporal effects. Consequently, consumption increases, and the comovement problem is resolved.

Explaining the durable goods co-movement puzzle: A Bayesian approach

A standard two-sector sticky price model with flexibly priced durables depicts negative comovement between durables and nondurables after a monetary policy shock, which is at odds with the empirical evidence. Several papers have addressed this issue with different model mechanisms, which can essentially be divided into three categories: financial frictions (on the production side or on the household side), stickiness in the price of productive inputs (labor or intermediate goods), and non-separable preferences between labor and composite consumption. While each mechanism can independently resolve the comovement problem, it is unclear which mechanism is empirically most relevant. This paper conducts a horse race among three alternatives that can resolve the puzzle in isolation, namely, a working capital channel with habit formation, sticky wages, and non-separable preferences, using a Bayesian approach. Based on the posterior estimates and a log marginal likelihood comparison exercise, the working capital channel combined with habit formation is the most important mechanism, as it can simultaneously resolve the comovement problem and fit the data well.

WHAT DO WORKING CAPITAL AND HABIT TELL US ABOUT THE CO-MOVEMENT PROBLEM?

Empirical studies find that expenditures on both durable and nondurable goods fall following a contractionary monetary policy shock. However, in standard two-sector models with staggered nondurable goods prices and flexible durable goods prices, consumption of durables rises whereas that of nondurables falls in response to a contractionary policy shock. To resolve this co-movement problem, I extend the model to include a realistic financial friction that firms must pay for their productive inputs prior to production, i.e., working capital, along with habit formation in nondurable goods consumption. Following a positive interest rate shock, the working capital channel raises production costs, thereby discouraging production of both durable and nondurable goods. Furthermore, habit formation induces households to smooth the growth rate of nondurable goods consumption, and hence mitigates the fall in the nondurable goods sector. The model solves the co-movement problem and successfully generates a more sensitive response in the durable goods sector, as observed in the data.

Consumption response to investment shocks under financial frictions

Consumption falls counter-factually on impact for investment-specific technology shocks, which, recent literature suggests, are important drivers of business cycles. Introducing financial frictions and variable capacity utilization to the standard New-Keynesian setup can overturn this co-movement problem, without imposing restrictions on wealth effects, or wage rigidities.

Capital, credit constraints and the comovement between consumer durables and nondurables

Evidence indicates that consumer durables are more flexibly priced than nondurable goods and services. In otherwise standard two-sector neoclassical sticky-price models with flexible durable prices, following monetary tightening, nondurables decrease but consumer durables increase. Friction in lending between households can resolve the comovement problem if durable prices are sticky. However, if durable prices are flexible, friction in lending fails to generate joint decline. This paper resolves the co-movement problem by adding capital into a model with flexible durable prices and friction in lending. When capital is needed in production, monetary tightening reduces the relative price of durables which induces investment and decreases firms' real profits in the short run. Due to fewer profits remitted from firms, savers have a lower disposable income and cannot increase expenditures on consumer durables as much as otherwise. As a consequence, aggregate consumer durables decrease and there is a joint decline of nondurables and consumer durables.

Non-separability and sectoral comovement in a sticky price model

This paper resolves the sectoral comovement problem between nondurable and durable outputs that arises in response to a monetary shock in a two-sector sticky price model with flexibly priced durable goods. We analytically demonstrate that the non-separability between aggregate consumption and labor can generate the comovement between nondurable and durable outputs in response to a monetary policy shock. We then estimate the degree of non-separability, together with other parameters, using a Bayesian approach. We find that the non-separable preferences are supported by the data and our estimated model generates the sectoral comovement in response to a monetary shock.

Nominal Rigidities, Monetary Policy and Pigou Cycles

Capturing the boom phase of Pigou cycles and resolving the comovement problem require positive sectoral comovement. This article addresses these observations using a two-sector New Keynesian model. Price rigidities dampen movements in the relative price of durables following a monetary policy shock. Durables and non-durables are estimated to be complements in utility, allowing for a resolution of the comovement problem for modest degrees of price rigidity. Nominal rigidities also make firms forward-looking in their pricing behaviour, which leads to relative price dynamics that generate positive sectoral comovement in the boom phase of a Pigou cycle.

Investment shocks and the comovement problem

Recent work based on sticky price–wage estimated dynamic stochastic general equilibrium (DSGE) models suggests investment shocks are the most important drivers of post-World War II US business cycles. Consumption, however, typically falls after an investment shock. This finding sits oddly with the observed business cycle comovement where consumption, along with hours-worked and investment, moves with economic activity. We show that this comovement problem is resolved in an estimated DSGE model when (i) the cost of capital utilization is specified in terms of increased depreciation of capital, as originally proposed by Greenwood et al. (1988) in a neoclassical setting, or (ii) there is no wealth effect on labor supply. The data, however, favors the first channel. Traditionally, the cost of utilization is specified in terms of forgone consumption following Christiano et al. (2005), who studied the effects of monetary policy shocks. The alternative specification we consider has two additional implications relative to the traditional one: (i) it has a substantially better fit with the data and (ii) the contribution of investment shocks to the variance of consumption is over three times larger. The contributions to output, investment, and hours, are also relatively higher, suggesting that these shocks may be quantitatively even more important than previous estimates based on the traditional specification.

Information flows and news driven business cycles

How do information flows influence business cycle dynamics in models with anticipated (news shocks) and unanticipated innovations? To address this question, we show how alternative specifications of news affect the equilibrium by deriving the mapping between news shocks and the endogenous variables in a simple analytical model. News shocks are shown to add moving average (MA) components to endogenous variables. We then show how the additional MA components affect equilibrium dynamics. We generalize two popular forms of news processes to demonstrate how information flows impact equilibrium dynamics. To compare these news processes, we establish conditions under which the two processes have identical information content. We find that allowing news shocks to be correlated across time generates hump-shaped impulse response functions and helps mitigate the comovement problem.

Examining Sectoral Co-Movement in Estimated Nominal Rigidities Models

Recently, Barsky et al. (2007) found that a sticky-price model does not generate sectoral co-movement and that the propagation mechanism is weak in response to monetary shocks if prices in the durable goods sector are significantly flexible, which raises a co-movement problem in sticky-price models. In this paper, we estimate sticky-price models with both durable and nondurable goods sectors in order to examine sectoral price stickiness and co-movement using actual data. The estimation results show that prices in both sectors are relatively sticky and the co-movement problem does not occur in the usual settings. We find, however, that the co-movement problem may occur when we introduce persistent price-markup shocks in a sticky-price model. We also estimate nominal rigidities models with sticky wages as well as sticky prices and find that sticky wages are helpful in explaining sectoral co-movement in addition to sticky prices.

Staggered wages, financial frictions, and the international comovement problem

Standard international real business cycle models often generate negative cross-country correlations in labor and investment. The data, however, display positive correlations. This paper studies the effect of real wage rigidity and financial frictions on international comovement. We find that staggered wages mainly improve the cross-country correlation of labor, while financial frictions improve investment comovement. However, each friction alone cannot account for the magnitude of international correlations of either variable. When the two imperfections are introduced together, the effect of each friction endogenously reinforces the other and the model generates realistic correlations in both variables.

Can non-traded goods solve the “comovement problem?”

The inability to replicate positive international comovement of investment spending and employment remains one of the most vexing issues facing the international real business cycle (IRBC) research program. To attack this so-called “comovement problem,” I develop a multisector IRBC model highlighting the role of non-traded goods and international capital mobility. In addition to broadly replicating prior IRBC successes, the model more importantly delivers positive international investment and employment correlations. The model is also able to generate internally the observed result that variables associated with traded goods sectors exhibit higher volatility than those in non-traded sectors.

The Trade Comovement Problem in International Macroeconomics

Recent empirical research finds that pairs of countries with stronger trade linkages tend to have more highly correlated business cycles. We assess whether the standard international business cycle framework can replicate this intuitive result. We employ a three-country model with transportation costs. We simulate the effects of increased goods market integration under two asset market structures: Complete markets and international financial autarky. Our main finding is that under international financial autarky the model can generate stronger correlations for pairs of countries that trade more, but the increased correlation falls far short of the empirical findings. In our benchmark calibrations, the model explains at most 6 percent of the responsiveness of GDP correlations to trade found in the empirical research. This result is robust to many combinations of shock specifications, import shares, and elasticities of substitution. Because the difference between business cycle theory and the empirical results cannot be resolved by changes in parameter values and the structure of the standard models, we call this discrepancy the trade comovement problem.

Relative prices, complementarities and comovement among components of aggregate expenditures

Abstract Recent work suggests that the standard real business cycle framework has difficulty accounting for co-movement among aggregate expenditure components when they are disaggregated even slightly to include business and household investment. In addition, relative prices of these goods have displayed substantial variation over the post-war period. This paper reports that incorporating a source of empirically plausible relative price variability makes the framework's implications for comovement even worse, compounding the comovement problem. The possibility that complementarities in the production of household and business capital may help account for observed co-movement is considered. The results suggest that complementarities improved the framework's empirical performance.