Source Themes

This paper proposes decomposing macroeconomic fluctuations into three components based on their contributions at different frequencies, to study the sources of business cycles. The first component explains business cycle fluctuations but has no long-run effect; the second has both; the third only long-run effects. The first two components jointly explain 99% of business cycle fluctuations and deliver comovements consistent with a structural interpretation as demand and technology shocks, respectively. The third component’s presence biases full-information estimation of business cycle models, distorting conclusions about the sources of business cycles. Estimating a model to match only business-cycle shocks resolves this issue and yields parameter estimates that are consistent with microeconomic evidence. The results also highlight the role of nominal wage rigidities in the expansionary impact of technology shocks on business cycles.

This paper identifies a key challenge in medium-scale DSGE models. These models tend to produce investment volatility nearly 100 times larger than what is observed in the data. This issue arises when we force these models to match both business cycle and long-run variance of ‘hours worked’. To address this problem, we develop a general equilibrium model where both wages and the rent on capital are determined by the present discounted values of the marginal product of labor (MPL) and the marginal product of capital (MPK), respectively. This model provides a solution to the documented empirical issue and highlights an important propagation mechanism in macroeconomic models.