Abstract
This paper analyses the relationship between CPI and real GDP in both the US and the UK using fractional integration and long-range dependence techniques. All series appear to be highly trended and to exhibit high degrees of integration and persistence, especially in the case of CPI. Since the two variables have different degrees of integration in each of the two countries, fractional cointegration tests cannot be carried out. We assume instead weak exogeneity of each of them in turn and test for causality by regressing the other variable against lagged values of the weakly exogenous one. We find that the only significant relationship implies the existence of a lagged effect of prices on output in the case of the US, which suggests a dominant role for demand shocks.
Highlights
The relationship between prices and output is crucial to understanding the nature of economic fluctuations and to be able to discriminate between rival macroeconomic models
In the Real Business Cycle (RBC) framework introduced by Kydland and Prescott (1990) business cycles are defined as deviations from trend, technology shocks are the main driver of cycles and the correlation between the cyclical component of output and the price level was estimated to be negative
The univariate analysis indicates that all series are highly trended and persistent, exhibiting high degrees of integration, especially in the case of consumer price index (CPI)
Summary
The relationship between prices and output is crucial to understanding the nature of economic fluctuations and to be able to discriminate between rival macroeconomic models. A lot of the literature in this area has focused on whether prices are procyclical or countercyclical, i.e. whether they move in the same or in the opposite direction to output This depends on the nature of the underlying shocks: aggregate demand and/or monetary policy shocks should produce procyclical behaviour, whilst aggregate supply (technology) shocks should result in countercyclical behaviour. Friedman and Schwartz (1963, 1982) analysed US business cycles from the Civil War and concluded that monetary shocks were the main source of aggregate fluctuations and that prices were procyclical, a stylised fact that macro models had to be able to replicate to be data congruent (Bernanke, 1986; Mankiw, 1989). Cooley and Ohanian (1991) found a positive correlation between output and inflation (as opposed to prices) during the post-war period
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