professor yamin ahmad, business cycles – econ 402 “business cycles: real facts and a monetary...

Professor Yamin Ahmad, Business Cycles – ECON 402

“Business Cycles: Real Facts and a Monetary Myth”

by Finn E. Kydland and Edward C. Prescott

in

Quarterly Review, Federal Reserve Bank of Minneapolis,Spring 1990, Vol. 14, No. 2, pp. 3 - 18

Presented by:

Professor Yamin Ahmad

Note: These lecture notes are incomplete without having attended lectures 2


Key Questions Addressed in the Paper

• How do you define or characterize a business cycle?

• What are some of the key statistics or stylized facts associated with business cycles?

• Are these statistics consistent with the implications of neoclassical theory?



Main Findings

• Findings dispute some commonly held beliefs:- Prices do not appear to be pro-cyclical, but instead

countercyclical!

Real wages appear to be highly procyclical, instead of acyclical or countercyclical.

The monetary base does not appear to lead the cycle, rather it appears to lag the cycle a little.

• Most of the other variables conform to predictions



Outline of the Presentation

• Definitions of the Business Cycle?

• Calculating the trend and cyclical components

• Results/Stylized Facts

• Summary and Conclusions



What is a Business Cycle?

• Burns & Mitchell (1946) have 4 phases that transition from one to the other:- Prosperity Crisis Depression Revival

• Frisch’s ([1933] 1965) Pendulum Distinguish between impulses (arising from random shocks)

and the propagation of these shocks.



What is a Business Cycle?

• Lucas (1977): An alternative way to view the business cycle Business cycle regularities: “comovements of the deviations

from trend in different aggregative time series” Defines the business cycle as: “movements about trend in

gross national product” Trend-Cycle decomposition

• Kydland and Prescott’s (1990) contribution: Explicit modeling of the trend View the trend as the steady state level of the particular

variable of interest (- coming out of growth theory)



Guidelines for modeling the trend

Kydland and Prescott (1990) use the following guidelines:• Trend component for real GNP should be approximately the curve that

students of business cycles would draw through a time series plot of this time series

• The trend of a given time series should be a linear transformation of that time series, and this transformation should be the same for all series.

• Lengthening the sample period should not significantly alter the value of the deviations at a given date, except possibly near the end of the original sample.

• The scheme should be well defined, judgment free, and cheaply reproducible



Trend Cycle Decomposition

• Let yt for t = 1,2,…,T represent a time series, denoted by the (natural) log of the variable, unless the variable is a share

• The trend component, tt for t = 1,2, …, T is one that minimizes:

• First order conditions for this convex minimization problem are linear and can be solved for tt.

• Kydland and Prescott (1990) find l = 1600 to be reasonable for the quarterly data that they use.

22

1 11 2

T T

t t t t t tt ty

Sum of squaredDeviations

(Cyclical component)

Sum of squared Trend components second differences



Data• Data is quarterly and ranges from 1954 – 1989.

• Data includes components of: Production inputs, e.g. labor and capital components Income and output components, e.g. consumption,

investment, etc Monetary aggregates and the price level

• Having decomposed the data into trend and cyclical components, Kydland and Prescott examine comovements in the cyclical components by computing correlations of variables at different leads and lags.



Results: Production Inputs

Leads the cycle Lags the cycle



Results: Output and Income Components



Results: Output and Income Shares



Results: Monetary Aggregates and Price Level



Summary

• Production components: Total hours is procyclical Capital stock is acyclical. However appears to lag the cycle

by about a year Employment lags the cycle, whilst hours per worker is nearly

contemporaneous with the cycle. Real wage appears to be procyclical



Summary (cont.)

• Output components All variables, e.g. Consumption and Investment are highly

procyclical One exception: Government purchases are acyclical Investment is a lot more volatile than GNP; consumption is

slightly less volatile

• Factor Incomes Labor income and capital income are strongly procyclical Capital income is highly volatile



Summary (cont.)

• Monetary Aggregates Monetary base does not appear to lead the cycle Monetary aggregates appear to be procyclical M2 appears to lead the cycle Velocity appears to be procyclical

• Price Level Prices appear to be fairly strongly countercyclical. Also appears to lead the cycle by about half a year.



Conclusions• Kydland and Prescott (1990) report statistics, or empirical

regularities that pertain to the business cycle.

• Use data from 1954 to 1989

• Key innovations in this paper are: how they decompose a time series into the trend and cyclical

components. a characterization of the phase differences of a business cycle

• Some findings are at odds with existing literature, e.g. prices, real wages and monetary base.

• The remainder conform to predictions of neoclassical theory

professor yamin ahmad, business cycles – econ 402 “business cycles: real facts and a monetary...

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