Expectations and the Business Cycle.

Abstract

There has been recent interest in the implications of expectations about changes in future fundamentals for the business cycle. This dissertation is broadly concerned with the identifcation and study of so-called "news shocks" about future productivity. The effects of news shocks shed light on several macroeconomic phenomena.

Chapter II proposes and implements a new approach for the empirical identificcation of news shocks. In a vector autoregression featuring a measure of aggregate technology and several forward-looking variables, the news shock is identifed as the structural shock orthogonal to technology innovations which best explains future variation in technology. In US data news shocks account for the bulk of low frequency variation in productivity; surprise innovations in measured technology are quite transitory. Favorable news shocks are positively correlated with consumption, stock price, and consumer con dence innovations, and negatively correlated with infation innovations.

Chapter III extends this analysis to study the business cycle implications of news shocks. Favorable news shocks lead to impact declines in output, hours, and investment, and an increase in consumption. After impact, aggregate variables track movements in technology. These are roughly the predictions of a wide class of pop ular macro models. The negative conditional comovement among macro aggregates stands at odds with the strong positive unconditional comovement of these series in the data, suggesting that news shocks are not a dominant source of fluctuations.

Chapter IV seeks to unveil the meaning of surprise movements in consumer confidence. Confidence innovations are disinflationary and are associated with slowly-building and permanent movements in economic activity. These impulse responses are consistent with confdence refecting information about future fundamentals; they are inconsistent with an important "animal spirits" component in which confdence reflects overly optimistic or pessimistic expectations.

Chapter V studies the interplay between nominal interest rate rules and forward-looking models of price-setting. It shows that the parameters of Taylor-type rules are, in general, identified in the New Keynesian model. Identification fails when the central bank is able to implement the flexible price equilibrium. The disinflationary nature of news shocks documented in Chapter II is inconsistent with the monetary authority achieving this goal.