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“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. Key Questions Addressed in the Paper.
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“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
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 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
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
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