Business Cycle Implications Research Articles

A Unified Theory of Ten Financial Puzzles

This paper o?ers a unified explanation for a host of puzzles about stocks, bonds and exchange rates. It builds on the Barro-Rietz view, that risk premia come from the probability of macroeconomic crises or disasters, and adds a variable intensity of disaster that can be asset-specific. Agents have stochastic assessments (which can be rational or behavioral) about the fundamental value that their assets would have if a disaster occurred. The model appears to explain the following puzzles on stocks, bonds and exchange rates: (i) equity premium puzzle (ii) risk-free rate-puzzle (iii) excess volatility puzzle (the fact that equity prices are so volatile) (iv) value-growth puzzle ( stocks with high price-dividend ratios have abnormally low future future) (v) upward sloping nominal yield curve (vi) Fama-Bliss findings that a higher slope of the yield curves predicts higher risk premia on bond returns (vii) corporate bond spread puzzle (the spread between corporate and government bond rates are higher than warranted by the U.S. historical experience) (viii) counter cyclical equity premium (ix) characteristics vs covariance puzzles (simple numbers such as the price-dividend ratio of stocks predict future returns better that covariances with economic factors (x) partial predictability of aggregate stock market returns by price/dividend ratios, and the consumption-asset ratio has explanatory power for future returns (xi) high price of deep out-of the money puts, and, last but not least, (xii) forward exchange rate premium puzzle (a.k.a. uncovered interest rate parity puzzle). Using the recent technique of linearity-generating processes (Gabaix 2007), the model is very tractable, and all prices are in closed form. Finally, the paper proposes a specification that integrate rare disasters with a standard real business cycle economy. In that specification, rare disasters change the asset pricing implications of the model, while keeping its business cycle implications completely unchanged.

Financial distress, bankruptcy law and the business cycle

This paper explores the business cycle implications of financial distress and bankruptcy law. We find that due to the presence of financial imperfections the effect of liquidations on the price of capital goods can generate endogenous fluctuations. We show that a law reform that ‘softens’ bankruptcy law may increase the amplitude of the cycle in the long run. In contrast, a policy of bailing out businesses during the bust or actively managing the interest rate across the cycle could stabilize the economy in the long run. A comprehensive welfare analysis of these policies is provided as well.

A Compromise Estimate of German Net National Product, 1851–1913, and its Implications for Growth and Business Cycles

We develop a compromise estimate of the German Net National Product for the years 1851–1913 based on four estimates from Hoffmann (1965) and Hoffmann and Müller (1959) by recalculating industrial production, investment, home and foreign capital income. Because differences remain during the early decades, we compute a weighted average compromise series. Economic activity is shown to be higher than the older estimates suggest. The average growth rate is lower. The average business cycle lasted five years, with high volatility in the early decades. The typical Gründerzeit pattern of boom then prolonged recession after 1873 can not be confirmed.

The Role of Collateralized Household Debt in Macroeconomic Stabilization

Market innovations following the financial reforms of the early 1980s relaxed collateral constraints on household borrowing. The present paper examines the contribution of this development to the macroeconomic stabilization that occurred shortly thereafter. The model combines collateral constraints on households with heterogeneity of thrift in a calibrated general equilibrium setup. We use this tool to characterize the business cycle implications of lowering required down payments and rates of amortization for durable goods purchases as in the early 1980s. The model predicts that this relaxation of collateral constraints can explain a large fraction of the actual volatility decline in hours worked, output, household debt, and household durable goods purchases.

Changes in the Factor Loadings across Sectors and Economic Dynamics: Evidence for the Japanese Firms

We estimate the equity premium for Japanese firms using the conditional version of Fama and French three-factor model where only the factor loadings are allowed to change unlike Liew and Vassalou (2000) wherein the factor premiums are allowed to change. Then, with considerations to the cyclical components of outputs with the RBC model we investigate the lead and lag relationships between the equity premium of the industry/sector and the measure of business cycles. We try to find the business-cycles related relationship between the cyclical components of the production index and/or GDP and the expected equity premiums for each industry among different sectors of the economy, notably the consumption goods sector and investment goods sector. The RBC model proposed by Boldrin, Christiano, and Fisher (1995, 2000) suggests that these differences exist. We also add a financial sector into this two sector model and then close the model with suitable equilibrium conditions. Within this model it is inferred that the financial sector will have also different business cycles implications. Furthermore, borrowing from the model proposed by Dias-Gomez et al. (1992), we will also be able to incorporate a banking sector, which would also possess different business cycle implications. The empirical relationship we find between the output fluctuations using a simple H-P filter at this first version of the paper and the equity premium changes for the various sectors of the economy shed a new light into the analysis of the business cycles and the equity premium changes, and hence the evolvement of the economy aggregate risk across different sectors of the economy.

Human Capital, Business Cycles and Asset Pricing

I investigate the asset pricing and business cycle implications of a dynamic stochastic general equilibrium model with human capital and education. Key features of the model are (1) a higher consumption risk resulting from the representative agent's desire to smooth leisure and from the short-run inelasticities in physical and human capital investment, and (2) a countercyclical risk aversion induced by shocks to human capital. The model provides a good fit to a number of asset-pricing facts including a low risk-free rate, an upward-sloping yield curve, a higher equity premium, countercyclical dividend yields, and long-horizon predictability of excess stock returns. On the macroeconomic side, the model matches conventional business-cycle statistics as well as a standard model does, while generating a high volatility in hours worked and a negative correlation between the output and the time spent in education, both of which are consistent with the data.

Understanding Electronic Commerce from a Historical Perspective

The aim of this paper is to use historical insights from modern commerce as entry points to examine the macro-level phenomena associated with electronic commerce (EC). Commerce in its modern form first appeared in early 13 th century Italy where conducive political conditions existed. Trade facilitated the exchange of goods, thereby enhancing the efficiency of processes between production and consumption. Even more important was its role in raising the level of human capital, promoting the spread of ideas and information, changing people’s attitudes and behaviour. Some modern business practices and institutions which evolved with modern commerce are bookkeeping, modern banking, commodities market, putting out systems (or outsourcing as we know it now), insurance, stock exchange, and venture capital. The current historical context favorable to EC is globalization. The emergence of network organizations helped to establish some of the practices supporting business-to-business electronic commerce. EC holds the potential to reduce time and transaction costs. However, the historical perspective suggests that the most profound implications of EC are likely to be at the macro-level or socio-institutional level. Some implications can already be seen while others are still developing. We are witnessing the impacts of EC on older business practices, and business models while there are likely implications for business cycles Such a perspective can provide pointers for future research. Lessons from history suggest a need to pay due attention to intervention at the socio-institutional level to reap the benefits of this form of commerce.

The Road to Adopting the Euro: Monetary Policy and Exchange Rate Regimes in EU Candidate Countries

This paper examines the choice of exchange rate regime in EU candidate countries during the process of accession to the European Monetary Union (EMU). In the presence of real exchange rate appreciation due to the Balassa-Samuelson effect, candidate countries face a trade-off between trend appreciation of the nominal exchange rate and high inflation rates. In a general equilibrium model of an emerging market economy, we show that under a fixed or heavily managed exchange rate the Balassa-Samuelson effect might prevent compliance with the Maastricht inflation criterion, unless a contractionary policy is adopted. We then discuss how the real exchange rate appreciation shifts the output gap/inflation variance trade-off, increasing the cost of managing or fixing the exchange rate. As a consequence, the requirement of membership in the Exchange Rate Mechanism (ERM-II) and the Maastricht inflation criterion constrain the policy choice while providing no additional benefit to countries credibly committed to joining the Euro. Finally, we show that relaxing either the exchange rate requirement or the inflation criterion has sharply different business cycle implications for the accession countries.

The Road to Adopting the Euro: Monetary Policy and Exchange Rate Regimes in EU Candidate Countries

This paper examines the choice of exchange rate regime in EU candidate countries during the process of accession to the European Monetary Union (EMU). In the presence of real exchange rate appreciation due to the Balassa-Samuelson effect, candidate countries face a trade-off between trend appreciation of the nominal exchange rate and high inflation rates. In a general equilibrium model of an emerging market economy, we show that under a fixed or heavily managed exchange rate the Balassa-Samuelson effect might prevent compliance with the Maastricht inflation criterion, unless a contractionary policy is adopted. We then discuss how the real exchange rate appreciation shifts the output gap/inflation variance trade-off, increasing the cost of managing or fixing the exchange rate. As a consequence, the requirement of membership in the Exchange Rate Mechanism (ERM-II) and the Maastricht inflation criterion constrain the policy choice while providing no additional benefit to countries credibly committed to joining the Euro. Finally, we show that relaxing either the exchange rate requirement or the inflation criterion has sharply different business cycle implications for the accession countries.

Measurement error in general equilibrium: the aggregate effects of noisy economic indicators

I analyze the business cycle implications of noisy economic indicators in the context of a dynamic general equilibrium model. Two main results emerge. First, measurement error in preliminary data releases can have a quantitatively important effect on economic fluctuations. For instance, under efficient signal-extraction, the introduction of accurate economic indicators would make aggregate output 10–30 percent more volatile than suggested by the post-war experience of the U.S. economy. Second, the sign — but not the magnitude — of the measurement error effect depends crucially on the signal processing capabilities of agents. In particular, if agents take the noisy data at face value, significant improvement in the quality of key economic indicators would lead to considerably less cyclical volatility.

Devaluation risk and the business-cycle implications of exchange-rate management A comment

Devaluation risk and the business-cycle implications of exchange-rate management A comment

Dynamics of Open Economy Business Cycle Models: Understanding the Role of the Discount Factor

This paper examines the dynamic implications of different preference formulations in open economy business cycle models with incomplete asset markets. In particular, we study two preference formulations: a time separable preference formulation with a fixed discount factor, and a time non-separable preference structure with an endogenous discount factor. We analyze the moment implications of two versions of an otherwise identical open economy model -- one with a fixed discount factor and the other with an endogenous discount factor -- and study impulse responses to productivity and world real interest rate shocks. Our results suggest that business cycle implications of the two models are quite similar under conventional parameter values. We also find the approximation errors associated with the solutions of these two models are of the same magnitude.

Measurement Error in General Equilibrium: The Aggregate Effects of Noisy Economic Indicators

I analyze the business cycle implications of noisy economic indicators in the context of a dynamic general equilibrium model. Two main results emerge. First, measurement error in preliminary data releases can have a quantitatively important effect on economic fluctuations. For instance, under efficient signal-extraction, the introduction of accurate economic indicators would make aggregate output 10 to 30 percent more volatile than suggested by the post-war experience of the U.S. economy. Second, the sign---but not the magnitude---of the measurement error effect depends crucially on the signal processing capabilities of agents. In particular, if agents take the noisy data at face value, significant improvements in the quality of key economic indicators would lead to considerably less cyclical volatility.

Computing the moments of the filtered variables in a state-space system

The business cycle implications of ‘real business cycle’ models are typically summarized by reporting the moments of the filtered model variables. In this letter a procedure to compute the exact moments of the filtered variables is described.

Productivity growth, consumer confidence and the business cycle

The objective of this paper is to provide, in the context of a dynamic general equilibrium model, an answer to the following five questions: 1. To what extent does an economy subject to regular variations in labor productivity growth differ from one where labor productivity is constant? 2. What is the impact on major macro indicators of a one-time change in labor productivity growth? 3. What are the business cycle implications of autonomous (non-falsifiable) changes in growth expectations? 4. What is the potential of such expectation changes for explaining the volatility of consumption to output ratio? 5. Can autonomous changes in growth expectations help us understand recent business cycle episodes?

Time to Plan and Aggregate Fluctuations

This article investigates the business cycle implications of the planning phase of business investment projects. Time to plan is built into a Kydland-Prescott time-to-build model, which assumes that investment projects take four periods to complete. In the Kydland-Prescott time-to-build model, resources for these projects flow uniformly across the four periods; in the time-to-plan model, few resources are used in the first period. The investigation determines that incorporating time to plan in this way improves the model's ability to account for three key features of U.S. business cycles: their persistence, or the fact that when output growth is above (or below) average, it tends to remain high (or low) for a few quarters; the fact that productivity leads hours worked over the business cycle; and the fact that business investment in structures and business investment in equipment lag output over the cycle.

Business Cycles and the Asset Structure of Foreign Trade

Since the primary role of international financial linkages is to facilitate consumption smoothing in the face of country-specific shocks, the degree of international financial integration should play an important role in the international transmission of business cycles. This paper therefore studies the business cycle implications of restricting international trade in financial assets. The key restriction is that domestic residents must hold all risky claims to domestic output, trading only noncontingent bonds on the international asset markets. We find that restricting asset trade may or may not change the business cycle implications of the model relative to complete markets, depending on the parameterization of the stochastic process for productivity. When there are important differences, these stem largely from differential wealth effects. We also find that restricting asset trade can resolve the chief problem inherent in complete markets models, which is their predictions of too-high consumption correlations and too-low output correlations. When technology follows a random walk process, the restricted asset markets model predicts that cross-country output correlations are positive, and cross-country consumption correlations are smaller than the output correlations, as is typically observed in the data.

Labor Contracts and Business Cycles

This paper investigates the claim, often put forth by real business cycle proponents, that the poor performance of their models in matching real-world aggregate labor market behavior is due to the fact that observed real wage payments do not correspond to the actual marginal productivity of labor but contain an insurance component that cannot be accounted for by the Walrasian pricing mechanism. To test this idea, we dispense with the Walrasian description of the labor market and introduce contractual arrangements between employees and employers. Assuming that employees are prevented from accessing capital markets and are more risk averse than employers, we use the theory of optimal contracts to derive an equilibrium relation between aggregate states of the economy and wage-labor outcomes. This contractual arrangement is then embedded into a standard one-sector, stochastic neoclassical growth model in order to look at the business cycle implications of the contractual hypothesis. The resulting dynamic equi...