Volatility in the knowledge economy

Summary. We seek to explain the economic volatility of the last 6 years, in particular the rapid expansion and contraction of the knowledge sectors. Our hypothesis is that these sectors amplify the business cycle due to their increasing returns to scale, growing faster than others in an upswing and contracting faster in a downswing. To test this hypothesis we postulate a general equilibrium model with two sectors: one with increasing returns that are external to the firm and endogenously determined – the knowledge sector – and the other with constant returns to scale. We introduce a new measure of volatility of output, a ‘real beta’, and derive a ‘resolving’ equation, from which we prove that the increasing return sectors exhibit more volatility then other sectors. We validate the main results on US macro economic data of real GDP by industry (2-3 digits SIC codes) of the 1977–2001 period, and provide policy conclusions.