We extend the Carlstrom and Fuerst (1997) agency cost model of business cycles by including time varying uncertainty in the technology shocks that affect capital production. We first demonstrate that standard linearization methods can be used to solve the model yet second moment effects still...

This paper reproduces Lucas's analysis of the costs of business cycles in an economy with a low probability, crash state in consumption growth. For reasonable parameter values, it is shown that the presence of a crash state dramatically increases the costs of consumption volatility....