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Persistent and Transitory Shocks, Learning, and Investment Dynamics

This paper introduces a new approach to understanding investment. The distinctive feature of our approach is that shocks to the economic fundamentals have both persistent and transitory components, and that firms must disentangle the persistent from the transitory shocks. The model generates interesting dynamics. Simulations of the model show that the response of investment to changes in the interest rate can vary widely over time, that the current response of investment depends on the sequence of past shocks, that investment will respond less when the firm is confident about its beliefs and more when a change in economic fundamentals challenges the firm's beliefs, and that investment booms and crashes may occur without any change in the true state of the economy. Simulations of the model also show that it captures many "stylized facts" of investment dynamics documented in previous empirical studies.

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File URL: http://www1.carleton.ca/economics/research/working-papers/carleton-economic-papers-cep-2001-2010/
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Paper provided by Carleton University, Department of Economics in its series Carleton Economic Papers with number 01-02.

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Length: 38 pages
Date of creation: 01 Feb 2001
Date of revision: Aug 2002
Publication status: Published: Revised version in Journal of Money, Credit and Banking, Vol. 34, No. 3 (August 2002), pp. 650–677
Handle: RePEc:car:carecp:01-02
Note: (figures not included in e-file) We are grateful to R. Chirinko, Michel & Fanny Demers, Avinash Dixit, Brian Erard, John Leahy, Bengt Lucke, Bruce Mizrach, Martin Zagler, and seminar participants at the American Economic Association, Board of Governors of the Federal Reserve System, Carleton University, Econometric Society, Georgetown University, HWWA - Institute for Economic Research (Hamburg), Institute for Advanced Studies (Vienna), University of Oregon, Rutgers University, and the Society for Nonlinear Dynamics and Economics for helpful discussion and comments. Any errors are our own.
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