A Real Explanation for Heterogeneous Investment Dynamics

Household investment, that is investment in consumer durables and housing, leads non-residential fixed investment over the U.S. business cycle. This observation represents a potent challenge to real business cycle (RBC) theory. First of all the theory has been unable to account for it. In addition, research suggests the observation is driven by monetary shocks, supporting the view that these shocks play a leading role in the U.S. business cycle. This paper shows that RBC theory is consistent with the investment dynamics after all. It does so by generalizing the standard home production environment to take into account the fact that household capital is useful in market production. ∗ Thanks to Lisa Barrow, Lawrence Christiano, Martin Eichenbaum, Eric French, Lars Hansen and seminar participants at the 2001 NBER Summer Institute for useful input. I would also like to thank Martin Eichenbaum and Randall Wright for encouraging me to write this paper. The views expressed herein are those of the author and not of the Federal Reserve Bank of Chicago or the Federal Reserve System.