Costly Labor Reallocation, Non-Separable Preferences, and Expectation Driven Business Cycles

A key feature of the business cycle data is that output, employment and investment move up and down together in different sectors of the economy. However, standard business cycle models fail to generate this business cycle sectoral co-movement. In this paper we propose a two-sector business cycle model that generates the sectoral cycle co-movement in response to both contemporaneous shocks and news shocks about fundamentals. The key elements to the model’s success are frictions in intersectoral labor mobility and non-separable preferences in consumption and leisure, along with adjustment costs to investment and variable capital utilization.