Real Business Cycle Literature Research Articles

Foreign direct investment inflows and business cycles

According to the stylized facts of the empirical real business cycle literature, investment is a procyclical variable, i.e. it co-moves with business cycles. Consequently, foreign direct investment's procyclical behavior is hypothesized and tested in this paper. A big sample of 74 (and 65 in the extended model) countries is used, and the hypothesis is tested on quarterly data with an average length of 90 periods, i.e. 22 years. Business cycles are identified by the Hodrick-Prescott filter, and the use of high-frequency data makes the results more precise and reliable. Using fixed effect regressions first the procyclicality of domestic investment is demonstrated, then the cyclical behavior of foreign direct investment is tested. Data shows that FDI is also procyclical. This result is robust, as it takes into account potential confounding variables. The paper's conclusion is that there is significant co-movement between foreign direct investment inflows and the recipient countries' business cycles.

‘Healthy’ Business Cycle

A macro-health model with endogenous survival probability dependent on health history builds in a real business cycle (RBC) framework three channels of endogenous health accumulation documented in various scientific disciplines: (1) health affects utility; (2) health affects productivity but depreciates with production; and (3) health is maintained with medical care or leisure activity. The model generates pro-cyclical health care expenditure and counter-cyclical life expectancy, in line with the data, and other aggregate properties seen in the RBC literature. All three channels work to the right direction in matching the observables, and their interactions also play a role in helping improve the model's quantitative fit.

Consumer Sentiment, Durable Consumption, and Stock Returns

I present an endowment economy where a representative agent has recursive preferences over the consumption of non-durable and durable goods, and uncertainty about the underlying endowments. Using parameter calibration consistent with real business cycle literature (risk aversion coefficient of 2.1 and elasticity of intertemporal substitution of 1.09), the model generates a high level of equity premium and a low and stable risk-free rate. The model is also able to explain up to 60% of the equity volatility. The volatile expenditure on durable consumption goods generates a high and volatile equity premium; endogenous time-varying uncertainty produces a counter-cyclical equity premium.

A dynamic model of an insurer: loss shocks, capacity constraints and underwriting cycles

PurposeThis paper aims to revisit the assumption of the cyclicality of the property-liability insurance market and identify a scenario in which the so-called underwriting cycles are unpredictable, according to a dynamic cash flow model which generates non-cyclical output dynamics.Design/methodology/approachThis paper is on the intersection of real business cycle models and financial cycles. The authors construct a dynamic model of an insurer’s cash flows with stochastic loss shocks and capacity constraints, in which loss shocks have a dual impact on both underwriting profits and access to external capital. They simulate the insurer’s optimal output responses to loss shocks, including output movements in underwriting coverage and external capital, to explore the source of unpredictable underwriting cycles through linear quadratic approximation in the model economy.FindingsThe authors find that the effect of loss shocks on the insurer’s cash flows could spread out and amplify over time because of the dynamic interaction between its underwriting capability and ability to raise external capital. This dynamic interaction can generate a non-cyclical pattern of changes in underwriting coverage and access to external capital in the benchmark economy. Applied to different experimental economies, the simulation results reveal that the determinants of the level of output fluctuations include the size of loss shocks, the sensitivity of capital market to loss shocks and the tightness of capital market.Originality/valueTo the best of the authors’ knowledge, there has been no attempt to study insurance output cyclicality with a dynamic cash flow model based upon the real business cycle literature, in which the dynamic interaction between underwriting and access to external capital because of loss shocks has an amplifying effect on output markets. This paper contributes to the current body of research by being able to simulate and show the insurance output dynamics resulting from the amplifying effect under capacity constraints.

What Prevents a Real Business Cycle Model from Matching the U.S. Data? Decomposing the Labor Wedge

I carry out a business cycle accounting exercise (Chari, Kehoe and McGrattan, 2007) on theU.S. data measured in wage units (Farmer (2010)) for the entire postwar period. In contrast toa conventional approach, this approach preserves common medium-term business cyclefluctuations in GDP, its components and the unemployment rate. Additionally, it facilitatesdecomposition of the labor wedge into the labor supply and the labor demand wedges. Usingthis business cycle accounting methodology, I find that in the transformed data, mostmovements in GDP are accounted for by the labor supply wedge. Therefore, I reverse a keyfinding of the real business cycle literature which asserts that 70% or more of economicfluctuations can be explained by TFP shocks. In other words, the real business cycle model fitsthe data badly because the assumption that households are on their labor supply equation isflawed. This failure is masked by data that has been filtered with a conventional approach thatremoves fluctuations at medium frequencies. My findings are consistent with the literature onincomplete labor markets.

What Prevents a Real Business Cycle Model from Matching the U.S. Data? Decomposing the Labor Wedge

I carry out a business cycle accounting exercise (Chari, Kehoe and McGrattan, 2007) on the U.S. data measured in wage units (Farmer (2010)) for the entire postwar period. In contrast to a conventional approach, this approach preserves common medium-term business cycle fluctuations in GDP, its components and the unemployment rate. Additionally, it facilitates decomposition of the labor wedge into the labor supply and the labor demand wedges. Using this business cycle accounting methodology, I find that in the transformed data, most movements in GDP are accounted for by the labor supply wedge. Therefore, I reverse a key finding of the real business cycle literature which asserts that 70% or more of economic fluctuations can be explained by TFP shocks. In other words, the real business cycle model fits the data badly because the assumption that households are on their labor supply equation is flawed. This failure is masked by data that has been filtered with a conventional approach that removes fluctuations at medium frequencies. My findings are consistent with the literature on incomplete labor markets.

A Toolkit for Value Function Iteration

This article introduces a Toolkit for Value Function Iteration. The toolkit is implemented in Matlab and makes automatic use of the GPU and of parallel CPUs. Likely uses are Teaching, Testing Algorithms, Replication, and Research. I here provide a description of some of the main components and algorithms. I also describe the design philosophy underlying choices about how to structure the toolkit and which algorithms to use. Rather than provide simple examples, something best done online (links are given), I instead perform a replication of a classic paper from the real business cycle literature as a demonstration of the use of such a toolkit. The Toolkit, Documentation, Examples, Replications, and more can be found at vfitoolkit.com

Macroelasticities and the U.S. Sequestration Budget Cuts

Microeconomic studies keep reporting that the intertemporal substitution in consumption and the Frisch elasticity of aggregate labor supply have significantly lower values than macroeconomic models find consistent with the dynamics of aggregate variables. The paper argues that in the U.S. such dynamics have been influenced since 2013 by the temporary spending cuts imposed by the so-called budget sequestration. The paper exploits the policy experiment features of that measure to gauge macroelasticity values from the evidence associated with it, adopting to that effect a macroeconomic model constructed according to the methodological principles advocated by the real business cycle literature. Readings of the preliminary evidence available at the time of this writing with such a measuring device do not particularly favor high values for either of the two macroelasticities under study. Although it’s too early to be conclusive, this finding illustrates how existing disagreements about the value of key macroelasticities can eventually be narrowed down by applying the approach proposed in this paper to the evidence coming out of the budget sequestration policy, as it unfolds over time. JEL Classification: E22, E24, E32, E65, J22. ∗The views expressed herein do not necessarily reflect those of the Federal Reserve Bank of Dallas, or the Federal Reserve System. Alan Armen provided superb research assistance. An earlier version of the paper was presented at the Spring 2014 Midwest Macroeconomics Conference and at the 2014 North American Summer Meeting of the Econometric Society. The paper benefited from comments received therein from Alexis Anagnostopoulos, Alexander Richter, Don Schlagenhauf, and Nathaniel Throckmorton. †E-mail: carlos.zarazaga@dal.frb.org. Address: Federal Reserve Bank of Dallas, Research Department, 2200 N. Pearl St., Dallas, TX 75201.

Investment Shocks: A Source of Fluctuations in a Small Open Economy

This paper contributes to the existing Real Business Cycle (RBC) literature by introducing Marginal Efficiency of Investment (MEI) shocks into small open economic model. Investment shocks are the most important drivers of business cycle fluctuations in small open economy because the fluctuations in all the macroeconomic variables showed a significant response to MEI shocks than productivity shocks. The anticipation of pro-cyclical behavior of the external accounts when the model was augmented with the form of share of consumption in the household utility function, μ, and an appealing, but complex, concave adjustment cost function becomes a standpoint that differentiates this study from other investment shocks literatures. The pattern of the rise in investment in both shocks explains why investment shocks is so important in times of recession and it reveals the main source of fluctuations in a small open economy.

Real business cycles in emerging economies: Turkish case

This paper attempts to answer the following question: Can a small-open-economy real business cycle (RBC) model driven by nonstationary productivity shocks explain business cycles in emerging economies? This question is addressed by estimating a dynamic stochastic general equilibrium model for Turkish economy using Bayesian methods in line with those suggested in the recent small open economy RBC literature. Results indicate that the standard RBC model driven by both stationary and nonstationary productivity shocks is not successful in replicating some of the key features of economic fluctuations. The alternative model with financial frictions provides a more realistic picture of business cycles.

China's economic fluctuations and consumption smoothing: Is consumption more volatile than output in China?

This paper provides a fundamental study of China's consumption and output fluctuations. The most recent literature reports that, in the post-1978 period, detrended consumption is significantly more volatile than detrended output in China. This indicates the inability to impose consumption smoothing. However, in those previous studies, consumption of durables, which has some features of capital, as discussed in the real business cycle literature, was not separated from private consumption. This paper is the first to estimate consumer durables for China and their service values following the method introduced in Cooley and Prescott (1995). We adjust the consumption measure to make it consistent with the real business cycle literature, and find that consumption of durables is much more volatile than output, but non-durable consumption is less volatile than, and less correlated with, output that provides evidence that supports consumption smoothing in China.

Financial integration within Europe and the international transmission of business cycles among industrialized countries

We exploit a dataset on financial integration within Europe to answer a novel question in the international Real Business Cycle (RBC) literature. Does financial integration within Europe matter for the international transmission of business cycles between the United States and Europe? We find that it does, and that as European countries become more financially integrated among themselves, European business cycles start to ‘decouple’ from those in the United States. We show that this is true for three macro indicators of economic activity: Gross Domestic Product (GDP), consumption and investment, and for five alternative measures of the degree of financial integration. We also show that the effect of trade linkages becomes insignificant once financial factors are accounted for. Our work has interesting policy implications since it unveils the importance of further integration in the EU to slow down the transmission of aggregate shocks among industrialized nations.

A dual measure of correlation between the Solow residual and output growth

In this paper, we measure U.S. technology shocks by implementing a dual approach, which is based on price data instead of aggregate quantity data. By doing so, we find the relative volatility of technology shocks and the correlation between output fluctuation and technology shocks to be much smaller than those revealed in most real-business-cycle (RBC) studies. Our results support the findings of Burside et al. (Eur Econ Rev 40:861–869, 1996), who showed that the correlation between technology shocks and output is exaggerated in the RBC literature. This suggests that one should examine other sources of fluctuations for a better understanding of the business cycle phenomena.

Endogenous Growth Mechanism as a Source of Medium Term Fluctuations in the Labor Market: Application to the US Economy

Endogenous Growth Mechanism as a Source of Medium Term Fluctuations in the Labor Market: Application to the US Economy

The return to capital and the business cycle

A widely cited failing of real business cycle models is their inability to account for the cyclical patterns of financial variables. Perhaps less well known is the fact that the returns to capital and equity are identical in the neoclassical growth model. This paper constructs a measure of the return to business capital for the U.S. The S&P 500 return is roughly six times more volatile than the return to business capital. Owing to the equivalence between the returns to capital and equity in the neoclassical growth model, papers in the real business cycle literature that successfully account for the time series variation in the S&P 500 return must fail to account for the time series properties of the return to capital. A fairly basic real business cycle model captures most of the observed variability in the return to capital. What is needed is a theory of the stock market that breaks the equivalence between the returns to equity and capital.

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Business cycles in Bulgaria and the Baltic countries: an RBC approach

This paper explores the business cycle in Bulgaria and the Baltic countries: Estonia, Latvia and Lithuania during the 1993-2005 period. The paper aims at deepening the understanding of the nature of output fluctuations. The neoclassical approach will be employed, much in the spirit of the real business cycle (RBC) literature, which gives a general equilibrium picture of the transition process. The model used in this paper follows the methodology of King et al. (1988). Both the model and data series show that the major drop in output was due to productivity. In addition, the timing of the banking reforms coincides with the improvement of economic performance. This is a strong indication that banking regulations in place were crucial for the output performance throughout the period in Bulgaria and the Baltic countries, a finding that has important implications for economic policy.

Price-Increasing Monopolistic Competition? The Case of IES Preferences

We introduce a new class of increasing elasticity of substitution (IES) preferences to model product differentiation. In a monopolistic competition setting a la Dixit - Stiglitz (1977) we find that, even under constant returns to scale and complete information, a rise in the number of firms can be price-increasing. This result extends to Cournotian competition. Despite the price increase, consumers benefit from a rise in the number of monopolistic competitors because of higher product diversity. Higher prices are therefore associated with higher consumer welfare. Our results suggest a possible explanation to the empirical puzzle posed by the countercyclical movements of price-cost margins following globalisation and market reforms. In addition, they should be of interest for real business cycle literature which investigates the impact of an endogenous market structure.

On the cyclical behavior of employment, unemployment and labor force participation

In this paper I evaluate to what extent a real business cycle (RBC) model that incorporates search and home production decisions can simultaneously account for the observed behavior of employment, unemployment and out-of-the-labor-force. This contrasts with the previous RBC literature, which analyzed employment or hours fluctuations either by lumping together unemployment and out-of-the-labor-force into a single non-employment state or by assuming a fixed labor force. Once the three employment states are explicitly introduced I find that the RBC model generates highly counterfactual labor market dynamics.

Consequences of Hodrick–Prescott filtering for parameter estimation in a structural model of inventory behaviour

Much work in macroeconomics relies on detrending a time series prior to analysis. A popular method of detrending has been the Hodrick–Prescott (HP) filter. This filter has been widely applied in the Real Business Cycle literature to isolate the behaviour of economic variables at business cycle frequencies and to look at comovements between series over the business cycle. Prior work has shown that the use of this filter can have serious consequences for such analysis, such as inducing spurious correlations, and that a researcher should proceed with caution when applying the filter. Another use of HP filtering has been to achieve stationarity prior to estimation of structural econometric models. Little work has been done concerning the possible effects this method of detrending may have on parameter estimation from such models. Given the problems with the filter noted in the literature, it is likely these effects may be of some consequence to estimation results. Using a common model of inventory behaviour, a simulation study is conducted to assess the impact of using the HP filter for detrending prior to estimation. A comparison will be made to other methods of handling trend to gauge relative performance.