Stochastic Trends and Fluctuations in National Income, Wages, and Profits

Abstract

Macroeconomics and especially the theory of business cycles went through very important changes during the last ten years. During the seventies most macroeconomists believed that economic activity evolved around a deterministic trend. Cyclical components and unanticipated changes in policy were believed to be the source of economic fluctuations. The real business cycle (RBC) models which began to emerge in the early eighties cast doubt on this belief. According to the RBC theory, the cumulative -effect of permanent shocks to productivity explains economic fluctuations. The proponents of the RBC theory assume that productivity shocks are exogenous and are not affected by aggregate demand shocks. Therefore, monetary shocks have no role in explaining economic fluctuations. In fact, according to the RBC theories, money responds positively to fluctuations in production induced by technological shocks. Therefore, the positive correlation between output and money is one of reverse causation. Critics of the RBC theories argue that productivity shocks cannot be treated strictly as exogenous. Evans [5] provides evidence that a significant portion of the variance of productivity impulse can be attributed to aggregate demand shocks. Another line of research by Christiano and Eichenbaum [4] shows that monetary-policy shocks have persistent liquidity effects as well as persistent increases in output. In this paper we investigate the role of monetary factors in explaining fluctuations in both