When Can Changes in Expectations Cause Business Cycle Fluctuations in Neo-Classical Settings?

Abstract

It is often argued that changes in expectation are an important driving force of the business cycle. However, it is well known that changes in expectations cannot generate positive co-movement between consumption, investment and employment in the most standard neo-classical business cycle models. This gives rise to the question of whether changes in expectation can cause business cycle fluctuations in neo-classical setting or whether such a phenomenon is inherently related to market imperfections. This paper offers a systematic exploration of this issue. Our finding is that expectation driven business cycle fluctuation can arise in neo-classical models when one allows for a sufficient rich description of the inter-sectorial production technology, however such a structure is rarely allowed in macro-models. In particular, the key characteristic which we isolate as giving rise to the possibility of Expectation Driven Business Cycles is that intermediate good producers exhibit cost complementarities (i.e., economies of scope) when supplying intermediate goods to different sectors of the economy.