Sunk investments, the churn, and macroeconomics.

• Author: Caballero, Ricardo J.

Behind the smooth path of macroeconomic aggregates, there is a very active microeconomic world. Massive flows of factors of production constantly are being reshuffled, while households are busy rebalancing their stocks of durables, real estate, or even their lifestyles. Market economies seem to handle this overwhelming "churn" with undeniable success, and it follows therefore that the eventual failure of economies that repress private initiative is perhaps unavoidable.

Is the dynamic nature of microeconomic actions and heterogeneity just a distraction to macroeconomists, or does it hide an important piece of information about aggregate dynamics? In this article, I argue that there are at least two reasons to conclude the latter. The first of these reasons is very direct: The mechanics of aggregate fluctuations are quite different from those of representative agent models. The second reason is more involved: An active churn requires a massive flow of transactions, and associated with these, an ongoing process of contracting and renegotiation. In this highly demanding environment, contractual problems and malfunctioning institutions soon accumulate and affect macroeconomic outcomes, and they become a major consideration for normative issues. For expositional simplicity, I discuss each of these themes in turn, although it should not be difficult to envision their close connection.

Micro Adjustment is Intermittent and Lumpy

If one looks more closely inside the active microeconomic world, a distinctive intermittent pattern arises. At the level of individual units, there are many economically relevant actions which occur only infrequently and in lumps. For example, we do not upgrade our cars daily; rather we do it infrequently, and when we do so the improvement over our old car is substantial. Similarly, the intermittent and lumpy nature of investment and labor demand decisions at the establishment level has been documented extensively U.S. manufacturing.(1) Rather than the result of perfectly synchronized and smooth microeconomic actions, aggregate activity is driven largely by the net outcome of dramatic actions by a limited fraction of individual units. Aggregate fluctuations are influenced heavily by changes in the degree of synchronization of these sporadic but lumpy individual actions.

There are several technological and institutional reasons why microeconomic adjustment is largely intermittent and lumpy, the simplest of which is the presence of fixed costs of adjustment. Giuseppe Bertola and I start from a model in which consumers face such costs when adjusting their stock of durable goods, and we then aggregate their lumpy actions, allowing for heterogeneous initial stocks of durables and idiosyncratic as well as aggregate shocks to their wealth. We show that such a model, albeit stylized, describes the quarterly behavior of purchases of U.S. durable consumer goods notably well. The estimated microeconomic adjustment costs and the degree of heterogeneity required to do so are reasonable.(2) Allowing for the same combination of ingredients - but with...