By Christoph Görtz and John Tsoukalas
An important disconnect in the news driven view of the business cycle formalized by Beaudry and Portier (2004), is the lack of agreement between different—VAR and DSGE—methodologies over the empirical plausibility of this view. We argue that this disconnect can be largely resolved once we augment a standard DSGE model with a ﬁnancial channel that provides ampliﬁcation to news shocks. Both methodologies suggest news shocks to the future growth prospects of the economy to be signiﬁcant drivers of U.S. business cycles in the post-Greenspan era (1990-2011), explaining as much as 50% of the forecast error variance in hours worked in cyclical frequencies.
News shocks are interesting because they are forward-looking, compared to the other shocks in the literature that focus on current conditions. In retrospect, it is thus natural that forward-looking features of the economy, like the financial sector, need to be included in a model to properly account for news shocks. This is what this paper does.