Download This PDF is a selection from a published volume from... Bureau of Economic Research Volume Title: NBER International Seminar on Macroeconomics

This PDF is a selection from a published volume from the National
Bureau of Economic Research
Volume Title: NBER International Seminar on Macroeconomics
2010
Volume Author/Editor: Richard Clarida and Francesco Giavazzi,
organizers
Volume Publisher: University of Chicago Press
Volume ISBN: 978-0-226-10736-3 (cloth); 0-226-10738-8 (paper)
Volume URL: http://www.nber.org/books/clar10-1
Conference Date: June 18-19, 2010
Publication Date: September 2011
Chapter Title: Comment on "Pigou Cycles in Closed and Open
Economies with Matching Frictions"
Chapter Authors: Paul Beaudry
Chapter URL: http://www.nber.org/chapters/c12205
Chapter pages in book: (p. 235 - 240)
Comment
Paul Beaudry, University of British Columbia and NBER
I.
Introduction
Inspired by ideas presented in Pigou’s 1927 book on Industrial Fluctuations, Pigou cycles refer to economic fluctuations that are driven by
changes in firms’ belief about the future profitability of current investment decisions. A recent literature has emerged exploring whether
Pigou’s ideas may offer a reasonable explanation to business cycle episodes (revival inspired in part by the episode of the tech boom-bust of
the 1990s). This literature has many challenges: theoretical, conceptual,
and empirical. For example, what is the source of the change in beliefs,
what are the transmission mechanisms, and are such forces empirically
relevant?
One of the immediate and less obvious challenges of this literature
is to identify environments in which such changes in beliefs can actually cause business cycles, that is, positive comovement between investment, consumption, and employment. Although such a possibility
sounds very intuitive, it is nontrivial to build fully specified (and reasonable) dynamic stochastic general equilibrium models in which
changes in fundamentals that affect the future profitability of current
investment actually generate business cycle phenomena. In a recent
paper, Den Haan and Kaltenbrunner (2009) have shown that news
about future productivity growth can generate business cycle phenomena in an environment in which jobs are subject to matching frictions.
However, their results are somewhat fragile since they depended on,
among others things, assuming a high degree of intertemporal elasticity
of substitution in consumption. In the current paper, Den Haan and
Lozej examine whether extending the analysis of the earlier paper to
an international setting allows Pigou cycles to emerge for more reasonable parameter values. The main result of the paper is to show that an
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236
Beaudry
international setting helps a search and matching framework generate
Pigou cycles for reasonable values of the intertemporal elasticity of substitution in consumption. However, Den Haan and Lozej also find that
for Pigou cycles to arise in an international context, it is important for
trade flows to affect relative prices of imported/exported goods.
In these comments, I will begin by reviewing why it is difficult to
produce Pigou cycles in a simple general equilibrium environment. I
will then discuss why matching frictions helps generate Pigou cycles
and how the introduction of open-economy elements affects the result.
Finally, I will provide a general assessment of the success and remaining challenges of this line of research.
II.
Expectation-Driven Fluctuation in a Two-Period Environment
Consider a two-period version of a standard one-sector macro model in
which output is given by
Yt ¼ θt Ktα Lt1α ;
t ¼ 1; 2:
The representative agent has per-period preferences given by
log ðCt Þ þ ϕ
ð1 Lt Þ1γ
:
1γ
The driving force is taken to be news regarding θ2 , with θ1 and K1
given. The question is, how does this economy respond to news about
θ2 when the news is known to individuals at time 1? The equilibrium
conditions for this two-period economy are
C1 ¼
C2
;
R
R ¼ θ2 ðαÞ
K2α1
;
L2
θ1 ð1 αÞ
K1α
¼ w1 ;
L1
θ2 ð1 αÞ
K2α
¼ w2 ;
L2
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Comment
237
w1 ¼ C1 ð1 L1 Þγ ;
w2 ¼ C2 ð1 L2 Þγ ;
C2 ¼ θ2 K2α L21α ;
θ1 K1α L11α þ ð1 δÞK1 ¼ C1 þ K2 :
When agents get positive news about θ2 , this increases demand for
current consumption, increases the demand for investment, lowers labor
supply, and leaves labor demand unchanged. Hence to equilibrate, market prices will need to adjust. In the new equilibrium, it is easy to verify
that R will be higher and consumption and wages in period 2 will be
higher. But instead of creating a boom in period 1, the news causes a recession with lower employment, output, and investment. The one quantity that increases is consumption. This result can be partially reversed if
preferences are instead given by
ct1σ
ð1 lt Þ1γ
þϕ
;
1σ
1γ
with σ < 1.
In this case, if σ is sufficiently small, then news can give rise to an
expansion in output, but now consumption will reduce. The problem
with this case is that it again does not look like a business cycle. This
simple example illustrates the difficulty in producing Pigou cycles in a
standard equilibrium environment.
Before I discuss the effects of introducting search frictions, it is useful to
review both why simply placing the above setup in an open-economy
environment will not solve the problem and why introducing nominal
frictions is not a clear solution either. Under the assumption of a small
open economy, good news about future productivity will now lead to
an increase in both consumption and investment, but it will create an even
greater domestic recession since employment and production will decrease more significantly in response to the consumption effects on labor
supply. Introducing nominal frictions can help to generate Pigou cycles,
but this has drawbacks also. In particular, results will depend on the nature
of monetary policy. If monetary policy is set optimally, then the economy
generally behaves as a flexible price economy, and therefore the problems associated with producing Pigou cycles illustrated above remain.
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238
III.
Beaudry
Adding Matching Frictions
How does adding matching frictions help? Matching frictions help on
two dimensions: they affect labor demand and they affect the wage determination process. First, consider the effect on labor demand. Matching frictions act like an adjustment cost to labor. Hence, if the arrival of
news causes a boom in employment next period, then this creates a
need to hire more workers today since workers cannot be immediately
hired at zero cost tomorrow. Given that more employment today means
more output, this allows both consumption and investment to increase
in response to the news. Second, the matching friction breaks the close
link between the wage and marginal value of leisure. For example, the
real wage can be thought as being quasi-fixed in such a case as long as it is
in the bargaining set. Den Haan and Lozej do not go as far as assuming a
fixed wage, but they do exploit this weaker link, thereby causing wages
to respond little to wealth effects of labor supply. Accordingly, with
matching frictions, news of a future boom leads to increased employment today at quasi-fixed wages.
So what is the problem with this case? If σ is sufficient low, we get business cycle properties. However, if σ is set at an empirically reasonable
value, we get a fall in investment as consumption absorbs all the extra
output and interest rates remain high. In this case we are getting consumption and employment to move together, which is generally a difficult comovement to get; however, the model is not causing business
cycle–type fluctuations since investment is not increasing.
Now we can see how adding an international dimension helps. The
matching friction is getting employment and output to increase, whereas
a pinned-down interest rate allows both consumption and investment to
increase. This all looks goods for generating Pigou cycles. However, as
recognized by Den Haan and Lozej, a new problem arises in such a setting: the trade balance becomes extremely volatile. Hence, Den Haan and
Lozej address this problem by adding trading frictions to better match
the observed volatility of the trade balance. They consider two cases: interest rates that respond to the trade balance and import/export prices
that react to import/export volumes. In the first case, they find that the
economy mimics very closely the closed-economy case. In the second
case, they find that the endogenous response of the price of investment
exports and consumption imports greatly helps the model generate
Pigou cycles. For example, the increase in the cost of imported consumption in response to news reduces the response of aggregate consumption and thereby favors even more production. The less obvious
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Comment
239
force is with respect to the price of investment goods. If the price of
imported investment goods did not change, the country experiencing a
positive news shock would not want to invest during the anticipation
phase, knowing it can wait for the realization of the news. Hence, it
would export investment goods instead of using them domestically to
build up the capital stock. But when this price falls as the country tries
to export (because of the friction), this creates incentives to invest domestically, and this favors the emergence of Pigou cycles in the sense of having consumption, investment, and output respond positively to news.
IV.
Remaining Challenges
This leads me to the question: Does this paper provide a credible mechanism for Pigou cycles, or at least is it on the right track? To answer this
question one needs to keep in mind that Pigou cycles are quite difficult
to generate in a reasonable equilibrium setting. Most current proposals
involve questionable departures from the baseline macro model. So in
comparison to the literature, this paper nicely highlights some attractive
features of how matching frictions help generate Pigou cycles. These frictions generate an expansion through a shift in labor demand—due to an
adjustment cost–type mechanism—along a rather unchanging wage (in
the bargaining set). That is intuitive. Such a mechanism seems at least as
plausible for explaining Pigou cycles as those found in the literature, and
moreover, it is shown to be quantitatively quite strong.
The mechanism is nevertheless still somewhat weak on other dimensions. In particular, the theoretical impulse responses reported in the
paper show that most of the movement in output comes about when
actual productivity is increased, not when the news arises. Why am I
worried about this? For this we need to look at evidence on news shocks.
Although the evidence related to “news-driven” business cycles is controversial, my work with Franck Portier (2006) and more recent work
with Bernd Lucke (2010) give some indication regarding what a model
of Pigou cycles needs to explain. In this work, we have been trying to
identify fluctuations induced by news shocks using structured vector
autoregression methodology. Our findings, using different identification
schemes, suggest that news of future growth in total factor productivity
(TFP) is preceded by a period of approximately 2 years in which the
economy is expanding without any increase in TFP. Most of the expansion period arises well before the increase in TFP. When TFP finally starts
increasing, this is not associated with a further boom. Throughout this
process, consumption, investment, and hours worked are high. These
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240
Beaudry
patterns are quite hard to match, and I believe that the current model
does not fit them very well. In this sense, I think further modeling work
is needed to explain business cycles as a response to news. Nonetheless, I
view the model of Den Haan and Lozej as potentially being the right
path.
References
Beaudry, Paul, and Bernd Lucke. 2010. “Letting Different Views about Business
Cycles Compete.” NBER Macroeconomics Annual 2009:413–56.
Beaudry, Paul, and Franck Portier. 2006. “News, Stock Prices and Economic
Fluctuations.” American Economic Review 96, no. 4:1293–1307.
Den Haan, W. J., and G. Kaltenbrunner. 2009. “Anticipated Growth and Business Cycles in Matching Models.” Journal of Monetary Economics 56:309–27.
Pigou, A. C. 1927. Industrial Fluctuations. London: Macmillan.
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