Authors: Stefano Eusepi and Bruce Preston

Standard real business cycle models must rely on total factor productivity (TFP) shocks to explain the observed comovement of consumption, investment, and hours worked. This paper shows that a neoclassical model consistent with observed heterogeneity in labor supply and consumption can generate comovement in the absence of TFP shocks. Intertemporal substitution of goods and leisure induces comovement over the business cycle through heterogeneity in the consumption behavior of employed and unemployed workers. This result owes to two model features introduced to capture important characteristics of U.S. labor market data. First, individual consumption is affected by the number of hours worked: Employed agents consume more on average than the unemployed do. Second, changes in the employment rate, a central factor explaining variation in total hours, affect aggregate consumption. Demand shocks—such as shifts in the marginal efficiency of investment, as well as government spending shocks and news shocks—are shown to generate economic fluctuations consistent with observed business cycles.