Real Business Cycle Research Articles

How important are trend shocks? The role of the debt elasticity of interest rate

We study how financial frictions affect the importance of trend productivity shocks for macroeconomic fluctuations. Using long-run data from 17 small open economies (SOEs), we compare two variants of a workhorse SOE real business cycle model featuring a debt-elastic interest rate (DEIR), a measure of financial frictions. The first variant estimates the DEIR parameter, while the second fixes it to 0.001, effectively abstracting from financial frictions. On average, ignoring financial frictions doubles the contribution of trend shocks to output fluctuations. This suggests that a proper assessment of the quantitative effects of trend shocks requires reasonable DEIR values.

Replicating business cycles and asset returns with sentiment and low risk aversion

I solve for the sequences of shocks (or wedges) that allow a standard real business cycle model to exactly replicate the quarterly time paths of U.S. macroeconomic variables and asset returns since 1960. The resulting shock sequences can be grouped into three main categories: (1) shocks that affect household sentiment and preferences, (2) shocks that appear in the law of motion for capital, and (3) shocks that appear in the production function for output. For most variables including output, no single shock category is clearly dominant in explaining the observed movements in U.S. data. While some variables are driven by a single dominant shock category, the dominant category is different for each of those variables. The results imply that there is no “most important shock.” Rather, U.S. economic outcomes have been shaped by a complex and time-varying mixture of fundamental and non-fundamental disturbances.

Fiscal financing with labour markets frictions

AbstractIn this paper, we study the effect of search and matching frictions, i.e., equilibrium unemployment, on fiscal financing decisions in the United States. We build a Real Business Cycle model with labour market frictions and a rich set of fiscal tools and estimate the model using Bayesian methods on US data for various fiscal rule specifications. Most importantly, we find that the model with unemployment, output and debt in the fiscal rules fits the data best. Under the fiscal rule that best fits the data, the reaction of fiscal instruments to output and debt are significantly quantitatively different than a rule that ignores unemployment. Fiscal instruments react stronger to cyclical factors except transfers. These changes also affect model dynamics in response to fundamental non‐fiscal shocks.

Macroeconomic effect of NBFC default shock in India: a four-sector DSGE model

ABSTRACT In this study a four-sector dynamic stochastic general equilibrium model is developed by introducing banks and non-banking financial companies (NBFCs) in a general two-sector real business cycle model in context of Indian economy. Examining the impact of three shocks namely NBFC default shock, productivity shock and investment shock, default of NBFC on its loan does not have any significant impact on aggregate output, consumption and investment. The shock has localized impact on the NBFC sector itself because of its low asset size and weak interconnectedness with the Indian economy. Productivity and investment shock have significant impact on the macroeconomic variables.

Employment creator or disrupter? Novel evidence for German import energy

ABSTRACT This paper uses the bootstrap rolling-window Granger causality test to investigate the relationship between energy import price (EIP) and unemployment rate (UR) in Germany. The finding reveals positive and negative influences of EIP on UR. The positive impact implies that the unexpected rise in EIP could strike the German employment market, which is supported by the real business cycle theory. However, this view cannot be confirmed by the negative influences owing to various reasons, including the fiscal and monetary policies adopted by the government to stimulate the economy. In addition, the influence of UR on EIP indicates that the change of UR is a vital indicator to forecast the EIP. Therefore, our findings prove the existence of a mutual connection between import energy and the domestic labor market. Since the German economy relies heavily on imported energy and resource-intensive industries, the detailed understanding derived from the relationship between EIP and UR will help policymakers optimize the domestic labor market and forecast the energy cost.

The development planning of the Italian Mezzogiorno: a statistical-mathematical analysis by a Real Business Cycle model

Since the 1950s, the regions of the Italian South (Mezzogiorno) have benefited from large in-kind transfers (namely, the provision of goods and services financed by the richer Northern regions) with the aim of favouring their economic development. The research aim of this manuscript is to evaluate this planning strategy, namely, to understand whether the territorial transfers boost the Mezzogiorno’s development or, on the contrary, whether the crowding-out effect of the final government expenditure on private investment and household consumption is the reason for the longstanding low growth of this geographical area.To accomplish this goal, the authors write down and solve an appropriate Real Business Cycle model and carry out some stochastic simulations. Their findings demonstrate that the in-kind transfer strategy entails no benefits for the Southern regions. In addition, the authors, using an alternative specification of their baseline setting, document that an alternative approach based on infrastructural investment is effective in stimulating the long-term economic growth of the Italian South.

Business cycle shocks according to the monetary approach The Turkish economy is a model for the period 2005-2021

The research aims to analyze the impact of fluctuations in monetary indicators on real indicators leading to business cycle shocks in Turkey. Based on the research hypothesis that the Turkish economy is affected by real business cycle shocks, positively or negatively, and varies according to the nature of the economy and the type of shock, whether monetary or real, the interrelation and interference between variables during... The cyclical movement within the economy results in reactions between variables that affect economic activity . To achieve the hypothesis of this hypothesis, the path of the direction of monetary indicators and their fluctuations, such as money supply, interest rates, and private bank credit, was traced, and their impact on the direction of flow of real indicators, such as gross domestic product, investment, and the unemployment rate. The study concluded that fluctuations in monetary indicators cause fluctuations in real indicators, creating two business cycles in The Turkish economy. The first is the result of an external shock represented by the American financial derivatives crisis in 2008 after the opening of the Turkish economy to the outside world. The second represents an internal shock due to the decline in the value of the Turkish lira in 2018. It is also noted that the impact of these monetary shocks is unequal in the real variables of output and investment. And employing according to the extent and depth of the shock occurrence, and the extent of the independence of the monetary authority

An Exogenous Risk in Fiscal-Financial Sustainability: Dynamic Stochastic General Equilibrium Analysis of Climate Physical Risk and Adaptation Cost

This research aims to explore the fiscal and public finance viability on climate physical risk externalities cost for building social-economic-environmental sustainability. It analyzes climate physical risk impact on the real business cycle to change the macroeconomic output functions, its regressive cyclic impact alters tax revenue income and public expenditure function; This research also analyzes that the climate physical risk escalates social-economic inequality and change fiscal-financial policy functions, illustrates how the climate damage cost and adaptation cost distorts fiscal-finance cyclical and structural equilibrium function. This research uses binary and multinomial logistic regression analysis, dynamic stochastic general equilibrium method (DSGE) and Bayesian estimation model. Based on the climate disaster compensation scenarios, damage cost and adaptation cost, analyzing the increased public expenditure and reduced revenue income, demonstrates how climate physical risk externalities generate binary regression to financial fiscal equilibrium, trigger structural and cyclical public budgetary deficit and fiscal cliff. This research explores counterfactual balancing measures to compensate the fiscal deficit from climate physical risk: effectively allocating resources and conducting the financial fiscal intervention, building greening fiscal financial system for creating climate fiscal space.

GENERAL ECONOMIC EQUILIBRIUM MODELS

The article examines the possibilities and limitations of empirical models of general economic equilibrium and makes their classification. Computable general equilibrium models are divided into two groups: the first group is based on the equilibrium price model (G. Scarf's approach), the second is based on a multi-sectoral model of economic growth (L. Johansen's approach). Dynamic stochastic general equilibrium models are also divided into two groups: the first group is based on the model of the real business cycle (the approach of F. Kydland and E. Prescott), the second is based on the model of various behavior of firms in conditions monopolistic competition (the approach of J. Rotemberg and M. Woodford). Within each group, empirical models were studied according to the following criteria: the scale of the economy, its openness; application for current and future assessments; socio-economic phenomenon under study.

Zero-risk weights and capital misallocation

Financial institutions, especially in Europe, hold a disproportionate amount of domestic sovereign debt. We examine the extent to which this home bias leads to capital misallocation in a real business cycle model with imperfect information and fiscal stress. We assume banks can hold sovereign debt according to a zero-risk weight policy and contrast this scenario to one in which banks weight the sovereign debt according to default probabilities. Banks are assumed to miscalculate the probability of a disaster state due to moral hazard and imperfect monitoring. This distortion pushes the economy away from the first-best allocation. We show that the zero risk weight policy exacerbates these distortions while a non-zero risk-weight improves allocations. The welfare costs associated with zero-risk weight policies are large. Households are willing to give up 3.2 percent of their consumption to move to the first-best allocation, whereas in the economy with non-zero risk-weights households are willing to give up only 1.2 percent of their consumption to move to the first-best allocation.

Macroeconomic determinants of multidimensional risk of Islamic banks across the world

Banking system crises and bank failures can have painful impacts. Being an Islamic Bank is riskier than being a conventional bank. As IBIs risk management emphasizes risk-sharing, conventional banks transfer their risk to borrowers. In our study, we have taken 4 risk factors which are Rate of Return Risk, Operational Risk, Credit Risk and Liquidity Risk, as a proxy of all the risks faced by IBIs and developed a Composite Risk Index using these major risk indicators of Islamic banks. Further, this study has proposed indicators like Size1 for liquid assets and Size2 for fixed assets, as in Islamic banks, there is no concept of money markets. The data for the research was collected from the secondary sources of Islamic banks’ financial statements, the EIKON database and World development indicators. The data for 96 Islamic banks were analyzed. The data was analyzed through Python, R and Stata. This study is instrumental in using the unsupervised machine learning clustering algorithm known as KMeans to estimate the prevalent risk level of the bank by aggregating four-dimensional risk indicators to form a single indicator. Moreover, the study explored macroeconomic determinants i.e., Asymmetric Stock Market, Real Business Cycle (GDP), Regulatory Quality and Economic Globalization of the Composite Risk Index and developed a channel via which it affects the risk level of banks. The results showed that in a country, better regulatory quality, higher fixed assets and economic boom in the business cycle play an important role in reducing the risk level of Islamic banks. This study provides a quantified contribution of Islamic banking to social welfare, compared to focusing on the numbers of risk indicators only and comparing it with fixed boundaries developed for the case other indicators.

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.

The Interaction between Credit Constraints and Uncertainty Shocks

AbstractThis paper proposes a novel link between credit markets and uncertainty shocks. We introduce a role for credit uncertainty via collateral constraints in an otherwise standard real business cycle (RBC) model and show that an increase in credit uncertainty triggers a precautionary response that interacts with the collateral constraint to generate a simultaneous decline in output, consumption, investment, real wages, and hours; a feature that previous work on uncertainty shocks without credit constraints is unable to produce in a flexible‐price environment. We also empirically test the theoretical predictions and show that an unforeseen increase in credit uncertainty generates a simultaneous decline in a broad measure of real activity in recessions.

Fat‐tailed DSGE models: A survey and new results

AbstractWe review recent advances in dynamic stochastic general equilibrium theory concerned with the emergence of fat‐tailed time‐series distributions. Focusing on mechanisms that are firmly grounded in structural equilibrium models, we provide a common reference framework to organize existing contributions according to whether they entail extreme business cycle swings as an endogenous response to small and short‐lived shocks (“thin in, fat out”), or rather as an automatic consequence of large and/or heteroskedastic exogenous impulses (“fat in, fat out”). Within the former class, non‐Gaussian features of equilibrium patterns can endogenously emerge in fully rational, Gaussian environments. Using an empirically plausible real business cycle framework, we also report novel simulation‐based evidence that helps reconcile theoretical predictions with the documented higher‐order properties of time‐series data for output measures.

Risk premium in a real business cycle framework

A real business cycle framework with financial and informational frictions is developed for a small open economy in order to analyze the implications of risk premium shocks for aggregate fluctuations. The frictions in the dynamic, stochastic, general equilibrium model necessitate financial intermediation and the uncertainty in the production process requires collateralized borrowing in the economy. Sovereign risk exists in the model due to a government that borrows domestically with a partial default risk. The associated risk premium that the government is subject to is captured both endogenously and exogenously, which constitutes one of the major contributions of this study to the literature. It is shown that a positive, temporary risk premium shock leads to an increase in government borrowing and a decrease in government spending due to the rise in the cost of borrowing for the government. The model also predicts a fall in output, labor supply and loans as well as a rise in the default probability of the government. The results confirm the findings of the literature with respect to the expected effects of a positive risk premium shock on a small open economy in a novel framework, where financial and informational frictions as well as sovereign risk as key features of emerging economies are captured and analyzed.

Fossil energy use and carbon emissions: An easy-to-implement technical policy experiment

<p>Macroeconomic research on carbon policy mostly revolves around carbon pricing mechanisms such as carbon taxes, cap-and-trade-schemes, and a mix of them. Despite their relevance, however, carbon pricing is not the only policy available to mitigate carbon emissions. A richer and diversified arsenal of carbon policies may prove more effective in addressing carbon mitigation across different social, economic and geographic contexts. We proposed a policy experiment, which took the form of a <italic>technical tax</italic> on fossil energy use aiming at stabilizing carbon dioxide emissions. The <italic>technical tax</italic> responded to variations in all elements that are supposed to alter climatic phenomena, that is, domestic carbon emissions, domestic fossil energy use, and the industrial stock of atmospheric carbon dioxide, to which all world economies contribute. The macro-effects of the <italic>technical tax</italic> were simulated using an off-the-shelf Real Business Cycles (RBC) model targeting the economy of the United States and featuring a climatic block. The economy was perturbed by a technology shock and an energy-price shock. Special care was devoted to the processes of validation and calibration. The tax was responsive to the business cycle and showed positive aspects. When a technology shock hit the economy, it curbed carbon emissions with minor costs in terms of potential output losses. It also protected the economy from an increase in energy prices, mitigating the fall in output despite the drop in fossil energy use. Last but not least, the tax effectively stabilized carbon dioxide emissions by reducing their variance.</p>

Taking Heterogenous Production Times into Account: The Emergence of Stickiness in Real Business Cycle Model

Taking Heterogenous Production Times into Account: The Emergence of Stickiness in Real Business Cycle Model

Real Business Cycle: Stochastic driving force decomposition of output dynamics in East Java

This study aims to examine output dynamics in East Java using the Real Business Cycle (RBC) model. We constructed an RBC model with two stochastic shocks originating from the demand and supply sides. The RBC model in this study shows that output dynamics, as the driver of the business cycle in East Java, are mostly caused by exogenous shocks originating from the demand side. The model also shows that some variables such as wage levels, consumption, and capital accumulation exhibit inertia patterns in response to shocks. Therefore, after releasing the assumptions underlying the RBC model and accommodating fiscal and monetary policies, we argue that the response time lag shown by some of these variables can be advantageous for authorities to mitigate the impact of shocks and determine policies. Additionally, two main factors that determine policy effectiveness are understanding the sources of shocks and the timing of policy implementation.

Endogenous Uncertainty and Credit Crunches

Abstract We develop a theory of endogenous uncertainty in which the ability of investors to learn about firm-level fundamentals is impaired during financial crises. At the same time, higher uncertainty reinforces financial distress. Through this two-way feedback loop, a temporary financial shock can cause a persistent reduction in risky lending, output, and employment that coincides with increased uncertainty, default rates, credit spreads, and disagreement among forecasters. We embed our mechanism into standard real business cycle and New-Keynesian models and show how it generates endogenous and internally persistent processes for the efficiency and labour wedges.

Do business cycles result from stochastic shocks?

Abstract According to the real business cycle theory, business cycles mainly result from random exogenous shocks. In this paper, this argument is tested. I extend the Wald–Wolfowitz runs test under the assumption that a recession lasts for two periods at least and an expansion lasts for $k$ periods at least with k ≥ 2. I apply the extended runs test to the three two-valued data recession-expansion series generated by the National Bureau of Economic Research and the Center for Economic and Policy Research. The test results reject the null hypothesis that they are generated in a random way for any $k$ even at the 1% significance level.