Abstract
We jointly estimate the U.S. business and financial cycle through a unified empirical approach while simultaneously accounting for 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 we document a positive unconditional correlation between the credit cycle and the output gap, the correlation of the lagged credit cycle and the contemporaneous output gap turns negative when we condition on a financial shock. The sign-switch suggests that the nature of the underlying shocks may be important for understanding the relationship between the business and financial cycles.
Highlights
The financial crisis of 2008-09 emphasized how developments in the financial market can spillover into the real economy, highlighting the importance to model and understand the role of the financial sector and how the financial sector of the economy interacts with the macroeconomy
From our more reduced form analysis, we find that a reasonable share of the positive output gap in the 2000s can be attributed to the excess bond premium, a credit spread constructed by Gilchrist and Zakrajsek (2012) to measure credit conditions through capturing the risk-bearing capacity of the financial sector
While we again stress that the informational decomposition is in reduced form, and so the role of these forecast errors should not be interpreted as causal, we briefly reconcile the differences we observe between the informational decomposition in Figures 3 and 4 with the structural decomposition in Figures 6 and 8 during the 2000s boom, given a key narrative is that financial factors appear to play a role in overheating the real economy, as indicated in our decomposition of the output gap and financial cycles
Summary
The financial crisis of 2008-09 emphasized how developments in the financial market can spillover into the real economy, highlighting the importance to model and understand the role of the financial sector and how the financial sector of the economy interacts with the macroeconomy (see, e.g. Adrian and Shin, 2010, for a review). It is important to understand the business and financial cycle because each is respectively used to understand imbalances in the real economy and financial sector. The key contribution of our paper is to jointly model the business and financial cycle within a unified empirical approach. Our unified approach goes beyond just estimating both the business and financial cycle within a common empirical framework. We show how our approach unifies the estimation of business and financial cycle with SVAR work which seeks to identify financial shocks. We take the output gap, or the cyclical component of real GDP, as the business cycle, and both the housing and credit cycle, or the cyclical component of house prices and credit, as the financial cycle
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