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Investment Shocks: the Labour Wedge and the Comovement Problem

Research output: Working paper

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Abstract

Shocks to the marginal efficiency of investment (MEI) play a significant role in business cycle fluctuations. However, in standard quantitative models, positive (negative) MEI shocks tend to cause consumption to fall (rise) on impact while investment rises (falls). This conflicts with the well-established observation that consumption and investment are both procyclical and move together over the business cycle. This paper demonstrates that MEI shocks can generate positive comovement between consumption and investment in a standard RBC
framework through the inclusion of a time-varying labour wedge. This allows for tractable analytical expressions, and straightforward graphical interpretations, which describe the subset of the parameter space where positive comovement is achieved.