Aggregate fluctuations with increasing returns to specialization and scale

The effects of technology shocks in a real business cycle model with monopolistic competition and increasing returns to both specialization and scale are considered. Market power per se and increasing returns due to fixed costs have no effect on the responses of aggregate variables to a technology shock relative to those exhibited by a standard, perfectly competitive real business cycle model. In contrast, the responses of aggregates to technology shocks are reduced by returns to scale in variable factors and increased by returns to specialization. Returns to specialization and scale also affect the measurement of technology shocks. Increasing returns to scale generally cause the variance of the Solow residual to undermeasure the variance of the 'true' technology shock, while returns to specialization result in the opposite bias. With both types of increasing returns present, the variance of output is increased relative to a standard competitive model despite a significant reduction of the variance of technology shocks.