The Effects of Permanent and Transitory Shocks under Imperfect Information

Abstract

The conventional framework in modern macroeconomics assumes that households know all information pertinent to the trade-o¤s they face and have rational expectations. Within this framework , they optimally adjust their behavior in response to disturbances in the economy in a way that is forward-looking. Thus, the persistence of shocks matters. Moreover, in an economy driven by shocks that differ in their degree of persistence, households can perfectly distinguish between these shocks. Permanent shocks move the economy to a new steady state while transitory shocks have no e¤ect in the long run. The idea that persistent and transitory shocks have di¤erent e¤ects in a setting where agents are forward-looking is well-documented. Blan-chard and Quah (1989), for example, use this fact to identify demand shocks as those that only have temporary e¤ects on unemployment and output but supply shocks as those that have permanent e¤ects on output. In a similar vein, King et al. (1991) identify permanent productivity shocks to the common trend in output, consumption, and investment. They …nd that permanent shocks account for over two-thirds of output ‡uctuations over the two-to …ve-year horizon. However, they also show that including nominal variables decreases the explanatory power of balanced-growth shocks on output ‡uctuations. The underlying class of models used, for example, by either Blan-chard and Quah (1989) or King et al. (1991), is one in which agents The views expressed in this paper are those of the authors and do not necessarily re ‡ect those of the Federal Reserve Bank of Richmond, the Federal Reserve Bank of San Francisco, or the Federal Reserve System. We thank Mark Watson for highlighting the imperfect information problem discussed herein and suggesting the solution we describe. We also thank Reiko Laski for outstanding research assistance.