Consumption heterogeneity, employment dynamics, and macroeconomic co-movement

Real-business-cycle models necessarily rely on total factor productivity shocks to explain the observed co-movement between consumption, investment, and hours. However, an emerging body of evidence identifies "investment shocks" as important drivers of business cycles. This paper shows that a neoclassical model consistent with observed heterogeneity in labor supply and consumption across employed and nonemployed can generate co-movement in response to fluctuations in the marginal efficiency of investment. Estimation reveals that these shocks explain the bulk of business-cycle variance in consumption, investment, and hours. A corollary of the model's empirical success is that the labor wedge is not important at business-cycle frequencies.