We offer a theory of economic fluctuations based on intertemporal incr
easing returns: agents who have been active in the past face lower cos
ts of action today. This specification explains the observed persisten
ce in Individual and aggregate output fluctuations even in the presenc
e of i.i.d shocks because individuals respond to the same shock differ
ently depending on their recent past experience. The exact process for
output, the sharpness of turning points and the degree of asymmetry a
re determined by the form of heterogeneity. Our general formulation, u
nder certain assumptions, reduces to a number of popular state space (
unobserved components) models. We find that on US data our general for
mulation performs better than many of the existing econometric models,
largely because it allows sharper downturns and more pronounced asymm
etries than linear models, and is smoother than discrete regime shift
models. Our estimates imply that only modest intertemporal returns are
needed for our model to explain US GNP, and that heterogeneity across
agents plays an important role in the propagation of business cycle s
hocks. (C) 1997 Elsevier Science B.V. All rights reserved.