Abstract:

This paper presents a business cycle model in which animal spirits shocks that arise from idiosyncratic productivity shocks generate the comovement of investment, consumption, hours worked, and inflation. In the comovement mechanism we fully characterize, real wage rigidity and diminishing returns to labor that stem from the presence of capital play a crucial role: a positive investment demand shock increases labor demand, decreases the marginal product of labor, and raises the marginal cost of final goods production. Our model features a firm's lumpy investment leading to a state-dependent multiplier effect, whose size is determined by a firm's capital profile within an inaction band. Lumpy investments propagated through aggregate demand externality offer a microfoundation for our animal spirits shocks and generate aggregate fluctuations without assuming aggregate exogenous shocks. Furthermore, by incorporating time-to-build for capital formation, the model is capable of accounting for autocorrelation structure.