Investment shocks and consumption

- MEI shocks do not generate co-movement between consumption and investment in standard models.
- This is a problem given the conditional and unconditional empirical evidence.
- A model with non-separable preferences and nominal rigidities delivers co-movement under general conditions.
- Alternative mechanisms (GHH, 1988) are successful only under more restrictive conditions.
- We distinguish the importance of complementarity from the size of the wealth effect on labor supply.

Several influential papers have argued that preferences featuring a weak wealth effect on labour supply are key to generate macroeconomic co-movement across real variables in response to shocks. Using a fully general specification for the instantaneous utility function, we show that the size of the wealth effect on labour supply is largely inconsequential for macroeconomic dynamics. Instead, we find that Edgeworth complementarity between consumption and hours worked is crucial in order to obtain co-movement of key macroeconomic variables. We consider investment shocks and we show that co-movement can easily be achieved with non-separable preferences in combination with a reasonable degree of nominal rigidity. This holds even in the presence of sizeable wealth effects.