A unified approach for jointly estimating the business and financial cycle, and the role of financial factors

Abstract

We jointly estimate the U.S. business and financial cycle through a unified empirical approach which also simultaneously quantifies the role of financial factors. Our approach uses the Beveridge-Nelson decomposition within a medium-scale Bayesian Vector Autoregression. First, we show, both in reduced form and when we identify a structural financial shock, that variation in financial factors had a larger role post-2000 and a more modest role pre-2000. Our results suggest that the financial sector did play a role in overheating the business cycle pre-Great Recession. Second, while an identified financial shock can generate a negative correlation between the lagged credit cycle and the contemporaneous output gap, the unconditional correlation between the credit cycle and the output gap is still positive. The latter at least suggests that one should be careful in associating an increase in the financial cycle to bust in the business cycle.