growthexpect-2007-10-0.5

Anticipated Growth and Business Cyclesin Matching Models : 

Anticipated Growth and Business Cyclesin Matching Models Wouter J. den haan Georg Kaltenbrunner

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Suppose there is convincing evidence that the third Industrial Revolution is going to lead to substantial productivity increases starting in a few years from now Question: What are the implications for employment, consumption, investment, and output?

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Growth Expectations in the 1990s

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The Economist: “Firms over-borrowed and over-invested on unrealistic expectations about future profits [...] The boom became self-reinforcing as rising profit expectations pushed up share prices, which increased investment and consumer spending.” Growth Expectations in the 1990s

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Are expected changes in future TFP important empirically? The Role of Growth Expectations Beaudry and Portier (2004b): Use bivariate VAR with TFP & stock market prices to identify anticipated changes in TFP Changes in TFP start slowly and then pickup, which is in stark contrast to the standard way of modeling TFP. This is very robust Isolate a burst in economic activity that pre-dates the TFP increase.

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TFP shock with and without adjustment for utililization

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Consumption response

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Models with multiple equilibria / coordination failure What about neoclassical business cycle models? Turns out it is very difficult Do we have a model that can explain this?

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Pigou cycles Let be the exogenous productivity shock Business cycles induced by rational growth expectations  while  i) Y  ii) C, I, N  Beaudry and Portier (2004a) show analytically that—at least initially—this is not possibly in a large class of models S

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Current value of  unchanged  If consumption and investment both increase then labour supply has to increase BUT, The wealth effect induces agents to work less Note that labour supply typically doesn’t even change very much in response to temporary changes in current TFP Why so difficult?

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But definition of Beaudry & Portier is very strict What if consumption initially dips and the rise in investment pushes consumption and hours up. BUT, Typically investment  (You need high intertemporal substitution, less than 0.5) Even if investment , takes a long time before consumption , because I/K and Y/K are low it is hard to increase consumption by investing more

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Output: Consumption: Investment: High elasticity of intertemporal substitution: Eventually both consumption and investment 

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Import goods from abroad you still have the wealth effect on hours increase in capital stock could push up wages but current wages are likely to be low relative to future wages Increased capacity utilization Beaudry and Portier framework allow for this This would show up as an increase in unadjusted TFP A reduction in agency costs could work at the micro level but at the macro level does not generate the additional resources needed to increase both consumption and investment (unless it provides the incentives to supply extra hours) Disequilibrium labor markets Reduction in labor supply wouldn’t matter What could increase Y keeping TFP fixed?

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Christiano, Motto, Rostagno 2006 Forward looking central bank and expected downward effect on inflation (Christiano, Motto, Rostagno 2006) you still have the wealth effect on hours increase in capital stock could push up wages but current wages are likely to be low relative to future wages Beaudry & Portier 2004, 2005 Complementarities Strong desire to increase consumption, so by making it costly for consumption and investment to move in opposite directions they won’t and increase in hours will finance their increase What could increase Y keeping TFP fixed?

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Jaimovitch and Rebelo (2006) Reduce negative labor supply effect by adjusting preferences Quadratic adjustment costs on investment growth  you want to spread out capital increases so if you know you want to increase capital in the future you start now What could increase Y keeping TFP fixed?

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Without these modifications: Economy’s respons to news about future TFP = Individual responds to news about a future windfall Maybe we model TFP too much like a windfall? Why so difficult?

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What is needed? a slack variable that can adjust You do not get the TFP increase automatically a reason the slack variable adjusts before TFP increases forward looking behaviour Proposed Solution (un)employment, that is, the extensive not the intensive margin only matched firms and workers benefit matching friction matching friction makes employment determination a dynamic problem

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  Expected Profits  Vacancies , Acceptance margin , (Destruction margin )  Employment   Output  Consumption , Investment  Intuition

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out of labor force free entry by new firms

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Productivity Process low growth low expectations Gt low growth high expectations high growth high expectations 0

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Employment Relationships 1 Firm, 1 Worker Productive until severed exogenously at rate Matched firm’s profits: Wages: Capital decision

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Firms’ free entry into matching market f is the firm’s matching probability Vt is the NPV of future firm profits

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Workers Employed, Nw: + wage – disutility of labor Unemployed, i.e., searching for a job, Ns: + chance of job & wage – disutility of search Out of the labor force, N*-Ns-Nw + utility of leisure Endogenous labor force participation  variable labor supply  negative wealth effect if anticipated growth 

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Matching Market Employment: matches:

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Firms’ free entry into matching market f is the firm’s matching probability Vt is the NPV of future firm profits

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Household Behaviour Chooses capital stock and labor supply (searching workers) Own capital stock Perfect risk sharing within the household

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Household Behaviour

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Capital Market equilibrium

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Additional Contributions Countercyclical unemployment rate in the presence of endogeneous labor force participation We avoid Ravn’s ConsumptionTightness puzzle

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Countercyclical unemployment rate Existing matching models with endogenous LF participation have difficulty in generating a countercyclical unemployment rate Reason: TFP   Participation   & vacancies   unemployment  This is related to Shimer’s point of matching models not generating enough vacancies Our model: TFP   Participation   & vacancies     unemployment 

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Ravn’s consumptiontightness puzzle = 0 and Nash bargaining [ ] & Vt proportional f & C- proportional inconsistent with volatile f & smooth C-

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Can this model generate Pigou cycles? Moving from low expectations to high expectations regime  Employment  & unemployment  Consumption  Investment  Output  Definition of investment: Investment in existing projects: K - (1-K) #1 + Investment in new projects Nv

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Using the strict Beaudry and Portier interpretation: NO Our timing assumption: K and N predetermined  in period of shock resources fixed Our model period is a month But, within a quarter output, employment, consumption and both forms of investment can increase

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Response of output (= NwZk ) Shock occurs

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Output minus investment in new projects(= NwZk -Nv ) Shock occurs

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Employment response Shock occurs

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Consumption and investment response Shock occurs

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Why doesn’t the standard wealth effect hurt us? It does! responses are better in the model without endogenous labor force participation Moreover, for our wage process the current wage decreases But desire of household to have worker “matched” when higher productivity occurs because of the matching friction workers you do not want to wait searching for a job

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Can expectation shocks generate a serious expansion? Actual increase in output

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Can expectation shocks generate a serious expansion? Cyclical output response

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Unfortunately not all results are robust Robust Output and employment increase and either consumption or investment increases Not Robust Both consumption and investment going up Non-robustness is surprisingly stubborn, but there is an easy fix …

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Both consumption and investment going up when …

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Easy fix: Allocation costs To keep on matching quantities and volatilities: Instead of:

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Conclusion  Labor market matching models can generate Pigou cycles Key mechanisms: Investment in new project now or you are too late Enter labor force now or you are too late Still a bit frustrating to need the allocation friction Key mechanism should possibly be extended to existing matches Invest/upgrade now or you are too late, for example, because Learning required to use new technology Early birds get more market share Early worm gets eaten