The Composition of Aggregate Demand, Division of Labor and the Business Cycle

Abstract

This paper introduces an internal propagation mechanism into a baseline multi-sector RBC model. The proposed mechanism, which is very similar to Keynes' spending multiplier in spirit, amplifies the impact of exogenous shocks significantly - a long-standing quest in the RBC literature. The main motivation for the mechanism is the following: the composition of consumption expenditures shows sizable cross-sectional differences across the population as a function of income and these differences determine the direction towards which people update their consumption bundle as their income change. In the paper, these observations are modeled through two types of agents (L and H-skill) who differ in terms of the occupations that they are specialized in and the composition of their consumption baskets. In addition, both types of agents have income dependent (non-homothetic) preferences which induce a strong desire to consume the good that the other type produces. To see how the resulting mechanism operates in response to a positive exogenous shock consider an innovator (H-skill) producing iPhones and a waiter (L-skill) producing dining services. A positive technology shock makes the innovator more productive and raises her income and with the additional income, she purchases relatively more dining services. This, in turn, raises the waiter's income as the demand for her labor services increases and with the additional income, she purchases a new iPhone, which creates further incentive for the innovator to work more. Importantly this second round work incentive for the innovator is not directly related to the original technology shock but to the demand from the waiter and that is exactly why the model generates significantly more amplification compare to other comparable RBC models.