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Unveiling Business Cycles: Myths and Realities

Explore the nature of business cycles and key findings challenging common beliefs. Learn about trends, stylized facts, and statistical implications in this insightful presentation based on Kydland and Prescott’s research.

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Unveiling Business Cycles: Myths and Realities

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  1. “Business Cycles: Real Facts and a Monetary Myth”by Finn E. Kydland and Edward C. PrescottinQuarterly Review, Federal Reserve Bank of Minneapolis,Spring 1990, Vol. 14, No. 2, pp. 3 - 18 Presented by: Professor Yamin Ahmad

  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?

  3. 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

  4. Outline of the Presentation • Definitions of the Business Cycle? • Calculating the trend and cyclical components • Results/Stylized Facts • Summary and Conclusions

  5. 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.

  6. 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)

  7. 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

  8. Trend Cycle Decomposition • Let ytfor 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, ttfor 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. Sum of squared Deviations(Cyclical component) Sum of squared Trend components second differences

  9. 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.

  10. Results: Production Inputs Leads the cycle Lags the cycle

  11. Results: Output and Income Components

  12. Results: Output and Income Shares

  13. Results: Monetary Aggregates and Price Level

  14. 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

  15. 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

  16. 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.

  17. 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

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