Introduction

A predominant focus of macroeconomic research in the last ten years has been on the origins of the business cycle. In particular, it has been popular to view the business cycle as arising from surprise movements in aggregate demand and to argue that these impulses are transmitted to real activity through movements in the price level. In order to generate empirically relevant fluctuations, however, such models must incorporate mechanisms to propagate price surprises over time. That is, to replicate economic fluctuations, it is necessary to transform serially uncorrelated price surprises into serially correlated macroeconomic time series. Unfortunately, despite the large amount of effort devoted in recent years to this type of equilibrium business cycle modeling, relatively little attention has been focused on isolating the empirically important propagation mechanisms.

More recently, we have pursued a line of research that we call “real business cycle theory,” in which disturbances are propagated over time as a result both of economic agents' desire to smooth commodity profiles and capitalistic production with rich intertemporal substitution opportunities. To date, however, these models incorporate only real supplyside or technological disturbances, abstracting from real demand-side influences (such as government spending) or nominal shocks. Nevertheless, the results on propagation mechanisms appear to be relevant for more fully developing the monetary theories of business fluctuation discussed above.

Of course, interest in propagation mechanisms is not new. Indeed, it was the major focus of many of the interwar business cycle theorists.