by Stefano Eusepi and Bruce Preston
Standard real-business-cycle models must rely on total factor productivity (TFP) shocks to explain the observed co-movement between consumption, investment and hours worked. This paper shows that a neoclassical model consistent with observed heterogeneity in labor supply and consumption, can generate co-movement in absence of TFP shocks. Intertemporal substitution of goods and leisure induces co-movement over the business cycle through heterogeneity in consumption behavior of employed and unemployed workers. The result is due to two model features that are introduced to capture important characteristics of US labor market data. First, individual consumption is affected by the number of hours worked with employed consuming more on average than unemployed. Second, changes in the employment rate, a central explanator of total hours variation, then affects aggregate consumption. Demand shocks — such as shifts in the marginal efficiency of investment, government spending shocks and news shocks — are shown to generate economic fluctuations consistent with observed business cycles.
A critical aspect of any business cycle model is the (intertemporal) substitution between consumption and leisure. In particular, this drives to a large extend the correlations between labor, consumption and investment. Traditional TFP based models have been critized for getting some of these correlations wrong, unless wealth effects are assumed away. This model is an attempt to replicate these correlations without TFP shocks and adopted a household whose members are unemployed in proportions varying through the business cycle.