When can changes in expectations cause business cycle fluctuations in neo-classical settings?

It is often argued that changes in expectation are an important driving force of the business cycle. However, it is well known 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 neoclassical models when one allows for a sufficiently rich description of the production technology; however, such a structure is rarely allowed or explored in macro-models. In particular, we identify a multi-sector setting and a setting with a costly distribution system in which expectation driven business cycles can arise. (c) 2006 Published by Elsevier Inc.