An investigation into expectations-driven business cycles

Abstract

<p>In this thesis I explore dimensions through which changes in expectations can serve as a driver of business cycles in a rational expectations setting. Exploiting both the ``sunspot'' and ``news-shock'' approaches to expectations-driven business cycles, I use various theoretical models to investigate how changes in expectations may have played a role in macroeconomic events such as the technological revolution of the 1990's and the financial boom and bust of 2003-2008.</p> <p>In the first chapter, I explore the ability of a model with knowledge capital to generate business cycles driven by expectations of future movement in total factor productivity (TFP). I model knowledge capital as an input into production which is endogenously produced through a learning-by-doing process. When firms receive news of an impending productivity increase, the value of knowledge capital rises, inducing the firm to hire more hours to ``invest'' in knowledge capital. The rise in the value of knowledge capital immediately raises the value of the firm, causing an appreciation in stock prices. If the expected increase in productivity fails to materialize, the model generates a recession as well as a crash in the stock market.</p> <p>In the second chapter, I explore the extent to which expectations about innovations in the financial sector may have contributed to both the boom and bust associated with the ``Great Recession''. Making a connection between the ``boom-years'' of easy credit and the crises of 2008, I argue that agents' overly-optimistic expectations of the benefits associated with financial innovation led to a flood of liquidity in the financial sector, lowering interest rate spreads and facilitating the boom in asset prices and economic activity. When the events of 2007-2009 led to a re-evaluation of the effectiveness of these new products, agents revised their expectations regarding the actual efficiency gains available to the financial sector and this led to a withdrawal of liquidity from the financial system, a reversal in credit spreads and asset prices and a bust in real activity. Following the news-shock approach, I model the boom and bust cycle in terms of an expected future fall in the costs of bankruptcy which are eventually not realized. The build up in liquidity and economic activity in expectation of these efficiency gains is then abruptly reversed when agents' hopes are dashed. The model generates counter-cyclical movement in the spread between lending rates and the risk-free rate which is driven purely by expectations, even in the absence of any exogenous movement in bankruptcy costs as well as an endogenous rise and fall in asset prices and leverage.</p> <p>In the final chapter, I explore the extent to which a ``bout of optimism'' during a period of technological change such as the 1990's could produce not just a boom in consumption, investment and hours-worked, but also rapid growth in productivity itself. I present a theoretical model where the economy endogenously adopts the technological ideas of a slowly evolving technological frontier, and show that the presence of a ``technological gap'' between unadopted ideas and current productivity can lead to multiple equilibria and therefore the possibility that changes in beliefs can be self-fulfilling, often referred to as sunspots. In the model these sunspots take the form of beliefs about the value of adopting the new technological ideas, and unleash both a boom in aggregate quantities as well as eventual productivity growth, increasing the value of adoption and self-confirming the beliefs. In this sense, the model provides an alternative interpretation of the empirical news-based results that identify expectational booms that precede growth in TFP. Finally, I demonstrate that the scope for the indeterminacies is a function of the steady-state growth rate of the underlying frontier of technological ideas, and that during times of low growth in ideas or technological stagnation, the potential for indeterminacies and thus belief-driven productivity growth diminishes.</p>