A Theory of Economic Fluctuations: Increasing Returns and Temporal Agglomerations

A competitive business cycle model is developed in which internal increasing returns translate a white noise random shock into temporarily agglomerated economic activity. Te qualitative nature of the economy varies over the cycle due to changes in the underlying economic structure, giving rise to asymmetries between expansions and contractions and necessitating a state space formulation for the model. Because of the nature of the increasing returns, our model displays considerable persistence as the response of the economy to a given shock depends upon the current state of the economy, which in turn is a function of previous disturbances. Our findings of qualitative differences, asymmetries and temporal agglomeration remain when we allow for aggregation over heterogeneous agents. In this case interactions between aggregate time series and cross sectional events play an important role in determining the form of output dynamics and the nature of cyclical asymmetries.