THE CYCLICAL BEHAVIOR OF PRICES: EVIDENCE FROM SEVEN DEVELOPING COUNTRIES

Abstract

NE of the stylized facts that characterize an economy over the business cycle is the movement of prices with real output. In the literature on the demand and real theories of business cycles, the two main theories state that if movements of output result from demand shocks, prices are expected to be procyclical; by contrast, if shocks originate from the supply side then prices are expected to be countercyclical. Lucas provided evidence in support of a positive correlation between prices and real output [24][25]. Olson also argues that newclassical as well as Keynesian economics agree on the positive correlation between the variables in relevance [28]. The same holds in Mankiw [26]. Cooley and Ohanian confirm the price countercyclicality for the United States [11], and Backus and Kehoe confirm it for other countries [1]. By contrast, other studies have reached the opposite conclusions (Bernanke [2]). The pioneering works of Kydland and Prescott [20] and Long and Plosser [23] initiated an attempt to explain certain stylized facts of U.S. business cycle behavior. This attempt—the so-called real business cycle theory—considered that what is responsible for the presence of business cycle phenomena are exogenous technological shocks and the accompanying propagation mechanism generated by the behavior of economic agents to optimize their behavior within an environment characterized by rational expectations and market-clearing conditions. These business cycle models attempt to explain the fluctuations in macroeconomic aggregates via the technological or any other “real” channel supporting the presence of an inverse relationship between prices and output. Mankiw has criticized real business cycle models on the grounds that they show that prices are not procyclical [26]. Countercyclicality of prices connotes that prices and output are negatively correlated. Moreover, the countercyclical behavior of prices suggests that real output