News Shocks and Business Cycles

T he discussion surrounding the recent deep recession seems to have shifted the focus from currently used business cycle models to the standard Keynesian model (by which we mean the “old Keynesian,” as opposed to the new Keynesian, model). In the Keynesian model, pessimism among consumers and investors about the economy will simultaneously lower aggregate consumption and aggregate investment, as well as aggregate output, through an increase in the rate of unemployment, and more generally through lower capacity utilization. Moreover, in the Keynesian model, pessimism and optimism are not determined within the model—they appear exogenously and they disappear exogenously. The analysis is then about how the economy reacts to these exogenous events. Undoubtedly, there are many indications that consumers and investors seemed pessimistic about their prospects during the recession, but does such pessimism necessitate the reversion back to the Keynesian model? The present article reviews and contributes to a recent strand of the “modern” business cycle literature, i.e., the literature that insists on building a model of the economy that is explicit about its microeconomic foundations and that addresses a related question: Can news shocks generate positive co-movement among our macroeconomic aggregates? An example of a negative news shock would be the sudden arrival of information indicating that future productivity will not be as high as previously thought. Thus, such a shock would generate current pessimism, and yet be grounded in real and fundamental developments. Another kind of news shock would be a government announcement about a policy change to be implemented on a future date (say, that taxes will be raised beginning next year). In this recent literature, thus, optimism and pessimism are examined as determinants of business