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Policy Discussion Paper, No. PDP 2008-3, June 2008
A Theory of Demand Shocks

This paper presents a model of business cycles driven by shocks to consumer expectations regarding aggregate productivity. The public signal gives rise to 'noise shocks,' which have the features of aggregate demand shocks: they increase output, employment and inflation in the short run and have not effects in the long run. The dynamics of the economy following an aggregate productivity shock are also affected by the presence of imperfect information: after a positive productivity shock output adjusts gradually to its higher long-run level, and there is a temporary negative effect on inflation and employment. A quantitative analysis suggests that noise shocks can produce sizeable amounts of short-run volatility. Moreover, a test based on survey data lends support to a central prediction of the model, regarding the overreaction of average expectations following a noise shock.

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