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Digitized by the Internet Archive in 2011 with funding from Boston Library Consortium IVIember Libraries http://www.archive.org/details/lumpyinvestmentiOObach DB/VEV HB31 ^ .M415 Massachusetts Institute of Technology Department of Economics Working Paper Series Lumpy Investment in Dynamic General Equlibrium Ruediger Bachmann Ricardo Caballero J. Eduardo M.R.A. Engel Working Paper 06-20 June 15,2006 RoomE52-251 50 Memorial Drive MA Cambridge, 02142 This paper can be downloaded without charge from the Social Science Research Network Paper Collection at httsp://ssm.com/abstract=9 0564 1 'TJSSiACHi^^gST™-! Lumpy Investment in Dynamic General Equilibrium Ruediger Bachmaiin Ricardo J. Caballero Eduardo M.R.A. Engel This draft: June 15, 2006 Abstract Microeconomic lumpiness matters for macroeconomics. According to our DSGE model, it explains roughly 60% of the smoothing in the iuvestment response to aggregate shocks. The remaining 40% is explainedby general equilibrium forces. The central role playedby micro frictions for aggregate dynamics results in important history dependence inbusiness cycles. In particular, booms feed into themselves. The longer an expansion, the larger the response ofinvestment to an additional positive shock. Conversely, a slowdown after a boom can lead to a long lasting investment slump, which is unresponsive to policy stimuli. Such dynamics are consistentwithUS investmentpattems overthe last decade. Morebroadly, over the 1960-2000 sample, the initial response ofinvestment to a productivity shock with responses in the top quartile is 60% higher than the average response in the bottom quartile. Furthermore, the reduction in the relative importance of general equihbrium forces for aggregate investment dynamics also facilitates matching conventionalRBC moments forconsumptionand employment. JEL Codes: El0, E22, E30, E32, E62 Keywords: (S, s) model, RBC model, time-varying impulse response function, aggregate shocks, sectoral shocks, idiosyncratic shocks, adjustmentcosts, historydependence, momentmatching. Lumpy Investment in Dynamic General Equilibrium Ruediger Bachmann Ricardo Caballero Eduardo M.R.A. Engel* J. This draft: June 15, 2006 Abstract Microeconomiclumpinessmattersformacroeconomics. AccordingtoourDSGEmodel, it explains roughly 60% ofthe smoothing in the investment response to aggregate shocks. The remaining40% is explained by general equilibrium forces. The central role played by micro frictions for aggregate dynamics results in important history dependence in busi- ness cycles. Inparticular, boomsfeedintothemselves. Thelongeranexpansion, the larger the response of investment to an additional positive shock. Conversely, a slowdown after a boom can lead to a long lasting investment slump, which is unresponsive to policy stimuli. Such dynamics are consistent with US investment patterns over the last decade. Morebroadly, overthe 1960-2000sample, theinitialresponseofinvestmentto aproductiv- ityshockwith responses in the top quartile is 60% higherthan the average response inthe bottom quartile. Furthermore, the reduction inthe relative importanceofgeneral equihb- riumforces foraggregate investmentdynamicsalsofacilitatesmatchingconventional RBC momentsforconsumptionandemployment. JELCodes: ElO, E22, E30, E32, E62. Keywords: [S,s) model, RBC model, time-varying impulse response function, aggregate shocks, sectoral shocks, idiosyncratic shocks, adjustment costs, history dependence, momentmatching. •Respectively: YaleUniversity; MITandNBER;YaleUniversityandNBER.Wearegratefulto OlivierBlanchard, WUliamBrainard,JordiGall,JohnLeahy,GiuseppeMoscarini,AnthonySmithandseminarparticipantsatNYUfor theircomments. FinancialsupportfromNSFisgratefullyacknowledged. Firstdraft:April2006. Introduction 1 Casual observation suggests that non-convexities in microeconomic capital adjustments is a widespread pattern. Doms and Dunne (1998) corroborate thisperceptionbydocumenting the lumpy nature of equipment investment in US manufacturing establishments. The question then arisesw^hetherornotthesemicroeconomic frictionsmatterformacroeconomic behavior. In this paper we incorporate lumpy adjustment in an otherwise standard dynamic stochastic general equilibrium (DSGE) model andconclude thattheydo. The main impact ofmicroeconomic lumpiness is to generate impulse responses for aggregate investment which are not only more persistent than in the standard RBC model, but also historydependent. Inparticular, thelongeranexpansion, thelargertheresponseofinvestment to furthershocks. Booms feedupon themselves. Conversely, aslowdovra afteraboom canlead to alonglastinginvestmentslump, whichis unresponsive to policystimuli. Such dynamics are consistentwdth US investmentpatterns overthelast decade. Figure 1: Impules Response in DifferentYears IRFsLumpy IRFsRBC — — — 196T 1966 1 a.16 - 1992 0.14 0.12 - i O.I - o.oa 0.06 - \ o,o*i \ o.oz \ - \\, s^ o.oz 20 26 More broadly, over the 1960-2000 sample, the initial response ofinvestment to a productivity shock with responses in the top quartile is 60% higher than the average response in the bottom quartile. Beyondtheinitialresponse, theleftpanelin Figure 1 uses ourmodel to generate entire impulse responses from shocks taking place at selectedpeaks and troughs ofthe US investment cycle.^ The variability ofthese impulse responses is apparent andlarge. Forexam- ple, between 1961 and 1966 the immediate response to a shock increased by more than 60%, from 0.070 to 0.115. The contrastwiththe right panel ofthis figure, which depicts the impulse 'As discussed later in the paper, the impulse response is normalized so that it would be equal to one in the absenceofpriceresponsesandadjustmentcosts.