Endogenous Productivity Dynamics in a Two-Sector Business Cycle Model

We develop a stylized two-sector business cycle model with endogenous firm dynamics in the investment goods sector. The positive correlation between firms' profitability and the relative price of investment goods generates an endogenous persistence mechanism in productivity dynamics which drives the model response to shocks. A white noise permanent shock to the productivity of new entrants causes endogenous exit and subsequent rounds of productivity increases, due to the competitive pressure generated by falling relative prices of investment goods. The model internal propagation mechanism generates persistent dynamics and a large ”multiplier effect” on the initial shock. Neutral productivity shocks affect long-run firms' productivity in the Investment-goods sector through their effect on relative prices. Firms' productivity is also endogenous to shocks to the marginal efficiency of investment. The DSGE version of the model apparently survives the Barro-King curse