Expectation Driven Firm Dynamics and Business Cycles∗

This paper presents a model incorporating endogenous firm entry (or product creation) that successfully translates positive news about the future into current expansions, and accounts for the positive comovements in output, consumption, investment and employment. The key elements are a time-variant sunk entry cost and variable capital utilization. In response to the expectation of future positive technology shocks, firms correctly predict the competition level will increase; they in turn reduce markup, which raises entry cost, and this consequently causes firms to choose to enter early. Along with firm entry, more intensive capital utilization stimulates new investment and employment, while expanding the production frontier; this facilitates a rise in both consumption and investment (even with a separable utility function). The model also successfully generates increases in stock prices (firm values), and positive comovements in response to a range of different shocks – preference shocks, exit shocks, and cost shocks.