Macroeconomic volatility in general equilibrium

Abstract

In this paper we explore the concept of excess volatility in general equilibrium. We show there is a fundamental tension between household efforts to smooth consumption and attempts by firms’ to smooth investment in the presence of convex adjustment costs in capital formation. Adjustment costs substantially diminish the ability of households to smooth consumption. As a result, consumption volatility will be significantly higher in the presence of adjustment costs than would be expected from the permanent income model alone. Moreover adjustment costs can cause consumption and asset process to change discontinuously at the moment of implementation of a previously anticipated event, a phenomenon that does not occur in models without adjustment costs.