Granger Causality and Equilibrium Business Cycle Theory

I investigate whether existing equilibrium business cycle models driven by demand shocks (in particular, government spending shocks) can rationalize the observed causal relationship when the following information structure is embedded: (i) Employment and output cannot respond to demand shocks immediately; they can do so only with a lag behind consumption. And (ii) investment cannot respond to demand shocks immediately; it can do so only with a lag behind output.3 Under these ad hoc assumptions, I first show that standard general equilibrium business cycle models do predict the existence of a causal chain from consumption to output and investment, but with the wrong sign. Namely, consumption growth negatively causes output growth, and output There is a “causal” relationship among consumption, output, and investment. Postwar U.S. data show that consumption growth “Granger-causes” gross domestic product (GDP) growth but not vice versa and that GDP growth in turn Grangercauses business investment growth but not vice versa.1 This unidirectional causal chain suggests that consumption contains better information about the source of shocks hitting the economy than does output, and output in turn contains better information about such shocks than does investment. This causal relationship cannot be explained by standard real business cycle (RBC) models. For example, under technology shocks, output contains the best information possible for the source of shocks; hence, it will not appear to be “Granger-caused” by consumption once the history of output is taken into account. To rationalize the causal relationship found in the U.S. data, it seems natural to consider demand shocks and to add a richer information structure into standard models such that demand shocks can affect consumption before affecting output and investment.2