Table Of Contents
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TThhiiss ppaaggee iinntteennttiioonnaallllyy lleefftt bbllaannkk
S u m r u G A l t u g
Koç University, Turkey &
Centre for Economic Policy Research, UK
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F a c t , F a l l
World Scientific
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Library of Congress Cataloging-in-Publication Data
Altug, Sumru.
Business cycles : fact, fallacy, and fantasy / by Sumru G. Altug.
p. cm.
Includes bibliographical references and index.
ISBN-13: 978-981-283-276-4 (hardcover)
ISBN-10: 981-283-276-9 (hardcover)
1. Business cycles. I. Title.
HB3711.A424 2009
338.5'42--dc22
2009034620
British Library Cataloguing-in-Publication Data
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Wanda - Business Cycles.pmd 1 1/13/2010, 1:50 PM
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Preface
How do intellectual disciplines progress? Undoubtedly, the discipline of
economics — and macroeconomics, in particular — is affected by major
changesineconomicconditions.TheGreatDepressiongreatlyinfluencedthe
perceptions of a generation of economists, beginning with Keynes. The oil
shocks of the 1970s and the 1980s affected economists’ views regarding the
sourcesofmacroeconomicfluctuations.
Sometimes,thedevelopmentofnewtechniquesornewwaysofmodeling
can also affect the course that a discipline takes. Large-scale computers in
the post-World War II era played an important role in the development of
simultaneous equation models. In recent years, real business cycle (RBC)
analysis has come to provide a flexible and popular approach for examining
macroeconomic phenomena. In 2004, Finn Kydland and Edward Prescott
received the Nobel Prize in Economics, and The Royal Swedish Academy
of Sciences published a report titled Finn Kydland and Edward Prescott’s
Contribution to Dynamic Macroeconomics: The Time Consistency of Economic
Policy and the Driving Forces Behind Business Cycles [204]. The field of
macroeconomics has changed significantly due to Kydland and Prescott’s
contributions.
ThisbookdrawsuponKydlandandPrescott’soriginalcontribution.Iwasa
Ph.D.studentattheGraduateSchoolofIndustrialAdministrationatCarnegie
MellonUniversitywhenKydlandandPrescott’s“Time-to-BuildandAggregate
Fluctuations” article was published in the early 1980s [141]. My thesis was
on estimating the model in the same article.The model was rejected, much
to the delight of macroeconomists of a more Keynesian bent! Yet many felt
thateconomicmodelsshouldbesubjecttoformaleconometricandstatistical
testing.Thisdebatecontinuestothisday.
v
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vi BusinessCycles:Fact,FallacyandFantasy
KydlandandPrescott’sseminalarticleinitiatedtheschoolofRBCanalysis.
This literature evolved in different ways. Talented and creative individuals
extendedtheinitialKydland–Prescottresearchindifferentways.Notcontent
with the initial rejection of the model, many researchers also pursued the
econometric analysis of RBC models. In recent years, researchers at central
banks have begun using so-called dynamic stochastic general equilibrium
(DSGE)modelsforpolicyanalysis.
This book attempts to provide an overview of the burgeoning business
cycle literature that, in many ways, reflects my own interests. There have
been a number of excellent publications that have examined different facets
of this literature. The volume by Thomas Cooley [74] can be considered a
primer of RBC analysis and its applications. James Hartley, Kevin Hoover,
and Kevin Salyer’s [116] collection of articles provides a critique of the
calibration approach. Jordi Gali’s [97] recent text articulates an alternative
New Keynesian framework for describing aggregate fluctuations. This book
takesamoreeclecticapproach,askingsomebasicquestionsaboutRBCanalysis
andsummarizingtheongoingcontroversiessurroundingit.
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Contents
Preface v
1. Introduction 1
2. Facts 7
2.1. DefiningaBusinessCycle . . . . . . . . . . . . . . . . 7
2.2. StylizedFacts . . . . . . . . . . . . . . . . . . . . . . . 15
2.3. TheEuroAreaBusinessCycle . . . . . . . . . . . . . . 19
2.4. IsThereaWorldBusinessCycle? . . . . . . . . . . . . . 25
2.5. HistoricalBusinessCycles . . . . . . . . . . . . . . . . 28
3. ModelsofBusinessCycles 33
3.1. AnRBCModel . . . . . . . . . . . . . . . . . . . . . . 34
3.2. ANumericalSolution . . . . . . . . . . . . . . . . . . 39
3.3. InitialCriticisms . . . . . . . . . . . . . . . . . . . . . 46
3.4. “Puzzles” . . . . . . . . . . . . . . . . . . . . . . . . . 48
3.4.1. AModelwithIndivisibleLaborSupply . . . . . . 49
3.4.2. TheProductivityPuzzle . . . . . . . . . . . . . 52
3.4.3. ReverseCausality . . . . . . . . . . . . . . . . . 56
3.5. TheSourceoftheShocks . . . . . . . . . . . . . . . . . 58
3.5.1. Investment-SpecificTechnologicalShocks . . . . 59
3.5.2. EnergyShocks . . . . . . . . . . . . . . . . . . 63
4. InternationalBusinessCycles 65
4.1. Facts . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
4.2. TheRoleofInternationalRiskSharing . . . . . . . . . . 68
4.2.1. ParetoOptimalAllocations . . . . . . . . . . . . 69
4.2.2. CompleteContingentClaims . . . . . . . . . . 71
vii
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viii BusinessCycles:Fact,FallacyandFantasy
4.2.3. NoAssetTrading . . . . . . . . . . . . . . . . . 75
4.2.4. NonspecializationinEndowments . . . . . . . . 77
4.2.5. NontradedGoods . . . . . . . . . . . . . . . . 78
4.2.6. TradeinEquityShares . . . . . . . . . . . . . . 79
4.2.7. LimitedRiskSharing . . . . . . . . . . . . . . . 81
4.3. OtherExtensions . . . . . . . . . . . . . . . . . . . . . 87
4.4. PuzzlesRevisited . . . . . . . . . . . . . . . . . . . . . 90
5. NewKeynesianModels 93
5.1. TheBasicModel . . . . . . . . . . . . . . . . . . . . . 94
5.2. EmpiricalEvidence . . . . . . . . . . . . . . . . . . . . 99
6. BusinessCyclesinEmergingMarketEconomies 101
6.1. A Small Open-Economy Model of Emerging Market
BusinessCycles . . . . . . . . . . . . . . . . . . . . . . 102
6.2. DoShockstoTrendProductivityExplainBusinessCycles
inEmergingMarketEconomies? . . . . . . . . . . . . . 106
7. MatchingtheModeltotheData 109
7.1. DynamicFactorAnalysis . . . . . . . . . . . . . . . . . 110
7.1.1. MeasuresofFitforCalibratedModels . . . . . . 113
7.1.2. OtherApplications . . . . . . . . . . . . . . . . 116
7.2. GMMEstimationApproaches . . . . . . . . . . . . . . 117
7.3. TheCalibrationversusEstimationDebate . . . . . . . . 119
7.3.1. TheDynamicsofOutput . . . . . . . . . . . . . 120
7.3.2. CalibrationasEstimation . . . . . . . . . . . . . 121
7.3.3. NonlinearityinMacroeconomicTimeSeries . . . 123
7.3.4. TheDebateReconsidered . . . . . . . . . . . . 127
7.4. DSGEModeling . . . . . . . . . . . . . . . . . . . . . 129
8. FutureAreasforResearch 137
Bibliography 139
Index 151
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Chapter 1
Introduction
In the opening page of the book Business Cycles published in 1927, Wesley
Mitchell [163] comments as thus: “As knowledge of business cycles grows,
more effort is required to master it.” Ever since, there have been many
developments in the field of business cycles. This book describes these new
developments.
Historically,thenotionofbusinesscyclesoriginatedfromvarioustypesof
panics, depressions, and crises experienced by market economies in the 19th
andearly20thcenturies.AccordingtoKarlMarx,oneofthemostprominent
thinkers of the time, “crises” are an endemic feature of capitalist economies.
As Mitchell [163] recounts, much effort was devoted to understanding the
causes of what many viewed as “abnormal” phenomena. However, other
economistsobservedthatthealternatingphasesofprosperityanddepression
seemedtofolloweachotheronaregularbasis,whenoneexaminedthehistory
of commercial cycles for the capitalist economies of the time. In the 1920s,
Kondratiev [137] argued that in addition to shorter economic cycles, there
wereperiodicmovementsor“longwaves”ineconomicvariables.Schumpeter
[187,188]soughttoexplaintheexistenceofsuchlongwavesasanoutcome
of technological innovations. In his framework, both growth and business
cyclescouldbeascribedtotheprocessofinnovation.Heidentifiedthreelong
waves:1780–1840,correspondingtotheIndustrialRevolution;1840–1890,
correspondingtotheintroductionofsteelandsteamengines;and1890–1950,
correspondingtotheinventionofelectricity,chemicalprocessing,andmotor
engines.
While some scholars proposed different theories to explain fluctuations
in economic activity, other scholars investigated methods for the systematic
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