Mikhail Golosov, Princeton University and NBER, and Guido Menzio, University of Pennsylvania and NBER

Agency Business Cycles

Golosov and Menzio propose a new theory of business cycles. Firms need to randomize over firing or keeping workers who have performed poorly in the past, in order to give them ex-ante an incentive to exert effort on the job. Firms want to coordinate on the outcome of their randomization, as coordination allows them to load the firing probability on states of the world when it is costlier for workers to become unemployed and, hence, it allows them to reduce the overall firing probability. In the unique robust equilibrium, firms use a sunspot to coordinate on the randomization outcomes and the economy experiences aggregate fluctuations that are endogenous — in the sense that they are not driven by exogenous shocks to fundamentals or by exogenous shocks to the selection of equilibrium — and stochastic — in the sense that they follow a non-deterministic path. The researchers' theory of business cycles implies a novel view of recessions which is opposite to a view of recessions as "rainy days" proposed by real business cycle theory.