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The role of expectations and expectation errors in business cycles Karnizova, Lilia Vladimirovna

Abstract

What drives business cycles? Traditional explanations, based on policy interventions and supply side changes, have been found empirically incomplete. This thesis examines the relative contribution of changes in beliefs to business cycles from theoretical and empirical perspectives. The first essay evaluates quantitatively the U.S. investment boom and bust of the late 1990s and early 2000s. Revisions of optimistic beliefs are commonly viewed as the key determinant of investment during this period. Yet, can this view explain consistently the joint behaviour of consumption, investment and employment? A standard real business cycle model with technology shocks performs relatively well in capturing the boom, but very poorly in explaining the bust. Beliefs about future technology are introduced into this model by enriching the economy information set and identified from a discrepancy between the model and the data. The augmented model can only account for the joint behaviour of aggregate variables when expectations about the future are more pessimistic during the boom and more optimistic during the recession. The second essay derives and tests a necessary condition for beliefs about future technology to be an independent source of business cycles. The essay's premise is that expectations are rational, but current and past realizations of technology do not fully summarize information relevant for forecasting future technology. This premise necessarily implies long-run predictability of technology shocks. Measures of total factor productivity, orthogonal to monetary and fiscal policy shocks, provide empirical support for this premise in the U.S. post World War II period. Macroeconomic variables help to forecast future realizations of TFP growth up to two years. The third essay asks whether changes in beliefs due to extra information about the future (news shocks) are different from changes in beliefs due to extrinsic uncertainty (sunspot shocks). The essay incorporates news into linear rational expectations models with unique and multiple equilibria. Based on general forms of solutions and numerical simulations of a New Keynesian model, the essay demonstrates that news and sunspots have distinct predictions for dynamic properties of equilibria. Since the differences can be quantitatively significant, these predictions can be used to separate news and sunspots empirically.

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