Asymmetric business cycles: Theory and time-series evidence

We offer a theory of economic fluctuations based on intertemporal increasing returns: agents who have been active in the past face lower costs of action today. This specification explains the observed persistence in Individual and aggregate output fluctuations even in the presence of i.i.d shocks because individuals respond to the same shock differently depending on their recent past experience. The exact process for output, the sharpness of turning points and the degree of asymmetry are determined by the form of heterogeneity. Our general formulation, under certain assumptions, reduces to a number of popular state space (unobserved components) models. We find that on US data our general formulation performs better than many of the existing econometric models, largely because it allows sharper downturns and more pronounced asymmetries than linear models, and is smoother than discrete regime shift models. Our estimates imply that only modest intertemporal returns are needed for our model to explain US GNP, and that heterogeneity across agents plays an important role in the propagation of business cycle shocks. (C) 1997 Elsevier Science B.V. All rights reserved.