A Unified Theory of Growth, Cycles and Unemployment - Part II: Business Cycles and Unemployment

The growth framework presented in part I of this paper is extended to include labour market frictions, resulting in a model that has interesting cyclical properties, including the following: (1) In response to investment-reducing shocks, the model endogenously creates recessions followed by drawn-out recoveries, closely resembling time series data on unemployment, output, investment and asset prices; (2) recessions are fully explained as periods during which frictions prevent instantaneous reallocation, resulting in (3) stock market crashes at the beginning of recessions; (4) the persistently elevated unemployment following recessions is explained as a result of investment dynamics; (5) the model incorporates a mechanism that strongly amplifies investment-reducing shocks while dampening investment-increasing shocks; this leads to (6) a pronounced asymmetry in business cycles, even for symmetric shocks; (7) the model further explains why output can be above trend during investment booms; (8) cyclical fluctuations can be triggered by a variety of shocks, including for example productivity or financial shocks; (9) the model is capable of expectation-driven cycles: the anticipation of future changes can trigger investment booms or recessions without the need for any contemporary productivity changes; (10) the shape of recessions and recoveries is largely driven by model mechanics, and does not rely on particular characteristics of the shock; (11) the model matches the usual cyclical correlations as well as typical RBC models, and in addition to that replicates the skewness of cyclical variables; (12) the model is simpler than most alternative business cycle frameworks and more robust with regards to its reliance on household characteristics for cyclical patterns.