Trendy Business Cycles and Asset Prices

Abstract

Abstract The data-generating process underlying productivity includes both trend and business cycle shocks, generating counterfactuals for prices under full information. In practice, agents’ inability to immediately distinguish between the two shocks creates “rational confusion”: each shock inherits properties of its counterpart. This confusion magnifies the perceived share of permanent shocks and implies that, contrary to canonical frameworks, transitory shocks are the main driver of long-run risk through trendy business cycles. With learning, the equity premium turns positive, while investment and valuation ratios become procyclical, as in the data. Consequently, rational confusion is key for reconciling disciplined macro-dynamics with equilibrium