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Home / Publications / Research / Economic Brief / 2022

Economic Brief
January 2022, No. 22-03

How Expectations About Future Productivity Drive
By Thomas A. Lubik, Christoph Gortz and Christopher Gunn

To what extent do expectations about future productivity developments drive
business cycles? This Economic Brief reviews the state of the literature and
discusses how new research by the authors establishes a novel method to
answer. We specifically focus on firms' inventories, which stock goods available
for future sales. We find that these inventories expand strongly to news about
future productivity developments. This confirms that expectations about future
productivity are a powerful force behind aggregate fluctuations, a finding with
important implications for widely used economic models.
The idea that beliefs and anticipation about future events are key drivers of business cycles
has received much attention over the past two decades. A specific aspect is the notion that
future productivity movements are revealed and believed by economic actors to some
extent in advance, so that they affect economic conditions today. Economists call such
anticipation of future events "news," and the arrival of such news is a "news shock," or an
unanticipated event that drives beliefs about future events.
In this article, we discuss our recent paper "Is There News in Inventories?," which identifies
such news shocks about future productivity developments in macroeconomic data and
evaluates economic mechanisms that transmit the shocks in the economy.
In addition, we frame our discussion in the context of inventories and their relevance for
understanding news shocks. This is a new aspect that has so far been neglected in the
literature but is a central element for business cycle theory and empirics.

Why Do Economic Actors React to News?

How can news about future events affect the economy? Consider the following: Suppose
you receive news of a substantial future pay raise. You might celebrate with a meal at a nice
restaurant or with the purchase of that long-wanted but far too expensive racing bike.
Typically, one would not wait for the higher pay to actually appear in the bank account but
would celebrate and consume now in anticipation of the higher pay in the future.
When projecting this example onto the whole economy in the context of news about future
technologies or productivity improvements, something analogous happens. Expectations
about future technological advances are associated with higher wealth in the future. This
makes households feel wealthier now and — like in the above example — causes higher
spending. In turn, this causes a rise in GDP before the new technologies are actually
The primary impact of a news shock is what economists call a wealth effect. Knowledge
about higher productivity, GDP and income in the future makes households feel wealthier
now than they really are based on the current fundamentals (namely current GDP and
Since consumers generally prefer similar consumption over the years — what economists
call consumption smoothing — they thus want to pull some of this future wealth forward
and enjoy it now. This raises consumption demand in the present when the news shock
arrives. It also puts downward pressure on labor supply since perceived future riches
reduce consumers' desire to work.
At the same time, there is a countervailing effect at play. Since productivity is anticipated to
be higher in the future, the cost of making things in the future will decrease. Consequently,
firms would want to shift production into the future to take advantage of these lower costs.
But to produce more things, firms also need to employ more workers, which have to be
hired at higher wages since the wealth effect wants them to work less.
Investment similarly faces conflicting forces. To be able to produce more cheaply in the
future, production capability has to be expanded, and the investment to do so has to be
started now. At the same time, increasing investment is cheaper in the future when
productivity is in fact higher.
This discussion leads us to speculate that all of these macroeconomic quantities move in
unison in response to news shocks: Anticipation of higher future productivity raises
consumption, investment, output and a potentially unclear effect on the labor supply. There
is a question of how strong these effects are based on an intertemporal substitution effect
that counters the wealth effect. But this would have to be decided by looking at the data.

Is There News in the Data?

The idea that shifts in expectations and beliefs about future technology can be powerful
enough to drive booms and trigger recessions has been recognized by economists for 100
years, as seen in the 1927 book "Industrial Fluctuations" by the British economist Arthur
Pigou. While the idea itself seems persuasive, actually measuring such news about
productivity is by no means straightforward.
Economists have suggested various methods to detect news shocks in the data and to
measure their effects. One method is to measure them directly via the effects of
expectations from data on the level of productivity. However, calculating the economy-wide
level of productivity is notoriously difficult and prone to a certain degree of measurement
error, which could affect the results on the economic effects of news shocks.
In recent years, the construction of productivity measures improved (as seen in the 2014
working paper "A Quarterly, Utilization-Adjusted Series on Total Factor Productivity"), and
methodologies were developed to minimize the distortionary effects of any remaining
measurement error (as seen in the 2021 paper "Revisions in Utilization-Adjusted TFP and
Robust Identification of News Shocks").
Alternatively, one can also think about a more indirect approach. For instance, movements
in stock prices — which arguably respond strongly to information about the future — can
be used to learn how expectations drive business cycles, as seen in the 2006 paper "Stock
Prices, News and Economic Fluctuations."
Recent studies also suggest proxying news about future technologies by using firms' patent
filings, as seen in the 2022 paper "Patent-Based News Shocks." The success of these indirect
approaches crucially hinges on whether variables — such as stock prices and patent filings
— are adequate proxies for expectations about future technology and whether they contain
sufficient information to be representative for the entire economy.
What these empirical studies have uncovered is that our speculation is accurate. In
response to news shocks, these macroeconomic quantities move in unison: An anticipation
of higher future productivity raises consumption, investment, output and the labor supply.
Moreover, this is consistent with the intuition outlined above, whereby the wealth affect
seems to dominate the intertemporal substitution effect.

What Role Do Inventories Play?
In comparison with existing research, recent work — the 2016 paper "What Do Inventories
Tell Us About News-Driven Business Cycles?," our 2020 paper "What Drives Inventory
Accumulation? News on Rates of Return and Marginal Costs" and the paper we're focusing
on in this article, "Is There News in Inventories?" — establishes a new layer of scrutinizing
the data for news by investigating how firms respond to technology news shocks by
changing the level of goods in stock for sale.

Inventories are suitable as a new litmus test to establish the relevance of expectations in
driving business cycles for two reasons:
Inventories arguably respond strongly to news because accumulating and holding
goods for sale is costly and requires forward planning.
Inventories are one of the key variables behind business cycle fluctuations in the sense
that reductions in the level of goods in stock account for a substantial share of the
decline in GDP during recessions.
For these two reasons, bringing inventories to the table can substantially enrich our
understanding of the relevance of shifts in expectations for business cycle fluctuations.
Inventory stock increases during booms and declines during recessions. This so-called procyclical behavior of inventories is widely documented. (An example would be the 2012
paper "Inventories, Inflation Dynamics and the New Keynesian Phillips Curve.") Arguably,
news shocks can then only be a relevant driving force for booms and recessions if they
cause inventories to follow this same pro-cyclical movement, as discussed in the
aforementioned paper "What Do Inventories Tell Us About News-Driven Business Cycles?"
For this reason, the response of inventories to news shocks can serve as a consistency
check on their importance in explaining business cycles.
Our research finds that, in response to positive news about future technology — measured
using a variety of direct and indirect approaches — not only do GDP, investment,
consumption and hours worked increase, but inventory stock also rises and hence moves
pro-cyclically alongside these quantities. This finding provides strong evidence for the
powerful force of news about productivity in driving business cycles.

Capitalizing on Knowledge to be Shocked by News
Economists use models as laboratories to analyze the behavior of the economy and to
organize their thinking about how to interpret patterns found in the data. Any reasonably
useful theoretical model should therefore be largely consistent with the empirical facts
under investigation.
In the specific case of news shocks, this means that a model needs to be able to generate
the empirically documented expansion in output, inventories, consumption, investment
and hours worked in light of news about higher future productivity. However, the standard
model for studying the effects of news shocks — as presented in the 2009 paper "Can News
About the Future Drive the Business Cycle?" — does not include inventories. When we
extend the standard model with inventories, as in our paper "Is There News in
Inventories?," we find that it is essentially impossible to generate an expansion of
inventories in response to a productivity news shock. In fact, inventories decline as the
intertemporal substitution effects dominate.

Why do inventories decline in the standard model? When news arrives, consumers feel
wealthier, and this drives up sales. Firms face two opposing effects:
They want to increase their stockholdings alongside sales to avoid stockouts.
They need to increase production to satisfy higher demand.
But increasing the inventory stock alongside higher sales is only possible with higher
production. Increased production, however, also implies that the costs of making things
increase at given level of workers, capital and productivity. In light of this, firms may actually
choose to draw down their inventories to avoid higher production costs and restock them
once higher productivity is realized in the future.
When we extend the standard model in our research to include inventories, the second
motive dominates the first, and inventories decline because these marginal costs rise
strongly. The key to resolving this issue is introducing another mechanism so that the first
effect actually dominates the second and, hence, inventories rise in response to news as
observed in the data. This mechanism is knowledge capital.

The Importance of Knowledge Capital
Knowledge capital is a firm's understanding of how to best make use of its resources
through expertise in organizing labor, operating machinery, using materials, etc. This
knowledge is accumulated while working on the job or engaging with production more
generally, a process that is often referred to as learning by doing, as noted by the 1962
paper "The Economic Implications of Learning by Doing."
In response to a news shock, firms increase their demand for labor since the value of
knowledge rises. This induces workers to increase their hours despite the desire to work
less because of the wealth effect. The rise in hours-worked expands firms' knowledge and
allows them to earn higher profits in the future when productivity eventually rises.
Importantly, this mechanism dampens the initial rise in marginal cost and thereby allows
for an expansion of inventories alongside the other macroeconomic aggregates.

It's News to Me: Implications for How Economists Think
About the World
Our study shows that this model can be a useful laboratory for the economy as it matches
the behavior we also see in the data. Moreover, we show that productivity news shocks in
this environment are a powerful force behind U.S. business cycles. Economists think about
business cycle fluctuations as the result of shocks to the economy. They are usually
categorized as monetary or fiscal shocks, shocks that spill over from foreign economies, or
changes in productivity.

Our research makes the case that news about productivity shocks — even when these
shocks have not even happened yet — is a powerful additional source of economic
fluctuations. And looking at inventories is a key way of figuring out what these shocks are
and when they occur.
Christoph Görtz is an associate professor of economics at the University of Birmingham.
Christopher Gunn is an associate professor of economics at Carleton University. Thomas A.
Lubik is a senior advisor in the Research Department at the Federal Reserve Bank of
This article may be photocopied or reprinted in its entirety. Please credit the authors,
source, and the Federal Reserve Bank of Richmond and include the italicized statement
Views expressed in this article are those of the authors and not necessarily those of the Federal
Reserve Bank of Richmond or the Federal Reserve System.

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