Changes in Growth Potential and Endogenous Technology Diffusion as Sources of Output and Asset Price Fluctuations

We develop a model in which innovations in an economy’s growth potential are an important driving force of the business cycle. The frame-work shares the emphasis of the recent ”new shock ” literature on revisions of beliefs about the future as a source of fluctuations, but differs by tieing these beliefs to fundamentals of the evolution of the technology frontier. An important feature of the model is that the process of moving to the frontier involves costly technology adoption. In this way, news of improved growth potential has a positive effect on current hours. As we show, the model also has reasonable implications for stock prices. We estimate our model for data post-1984 and show that the innovations shock accounts for nearly a third of the variation in output at business cycle frequencies. The estimated model also accounts reasonably well for the large gyra-tion in stock prices over this period. Finally, the endogenous adoption mechanism plays a significant role in amplifying other shocks.