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When Can Changes in Expectations Cause Business Cycle Fluctuations in Neo-Classical Settings?

  • Beaudry, Paul
  • Portier, Franck

It is often argued that changes in expectation are an important driving force of the business cycle. It is well known, however, that changes in expectations cannot generate positive co-movement between consumption, investment and employment in the most standard neo-classical business cycle models. This gives rise to the question of whether changes in expectation can cause business cycle fluctuations in any neo-classical setting or whether such a phenomenon is inherently related to market imperfections. This Paper offers a systematic exploration of this issue. Our finding is that expectation driven business cycle fluctuations can arise in neo-classical models when one allows for a sufficiently rich description of the inter-sectorial production technology; however, such a structure is rarely allowed or explored in macro-models. In particular, the key characteristic which we isolate as giving rise to the possibility of expectation driven business cycles is that intermediate good producers exhibit cost complementarities (i.e., economies of scope) when supplying goods to different sectors of the economy.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 4628.

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Date of creation: Sep 2004
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Handle: RePEc:cpr:ceprdp:4628
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  1. Basu, Susanto & Fernald, John G, 1997. "Returns to Scale in U.S. Production: Estimates and Implications," Journal of Political Economy, University of Chicago Press, vol. 105(2), pages 249-83, April.
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