MACROECONOMIC VOLATILITY IN GENERAL EQUILIBRIUM

In this paper we explore the concept of excess volatility in general equilibrium.
We show there is a fundamental tension between household efforts to smooth
consumption and attempts by firms’ to smooth investment in the presence of
convex adjustment costs in capital formation. Adjustment costs substantially
diminish the ability of households to smooth consumption. As a result,
consumption volatility will be significantly higher in the presence of adjustment
costs than would be expected from the permanent income model alone. Moreover
adjustment costs can cause consumption and asset prices to change
discontinuously at the moment of implementation of a previously anticipated event,
a phenomenon that does not occur in models without adjustment costs.