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Professor Yamin Ahmad, Business Cycles – ECON 402
“Business Cycles: Real Facts and a
Monetary Myth”
by Finn E. Kydland and Edward C. Prescott
in
Quarterly Review, Federal Reserve Bank of Minneapolis,
Spring 1990, Vol. 14, No. 2, pp. 3 - 18
Presented by:
Professor Yamin Ahmad
Professor Yamin Ahmad, Business Cycles – ECON 402
Key Questions Addressed in the Paper
• How do you define or characterize a business cycle?
• What are some of the key statistics or stylized facts
associated with business cycles?
• Are these statistics consistent with the implications of
neoclassical theory?
Note: These lecture notes are incomplete without having attended lectures
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Professor Yamin Ahmad, Business Cycles – ECON 402
Main Findings
• Findings dispute some commonly held beliefs: Prices do not appear to be pro-cyclical, but instead
countercyclical!
 Real wages appear to be highly procyclical, instead of
acyclical or countercyclical.
 The monetary base does not appear to lead the cycle,
rather it appears to lag the cycle a little.
• Most of the other variables conform to predictions
Note: These lecture notes are incomplete without having attended lectures
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Professor Yamin Ahmad, Business Cycles – ECON 402
Outline of the Presentation
• Definitions of the Business Cycle?
• Calculating the trend and cyclical components
• Results/Stylized Facts
• Summary and Conclusions
Note: These lecture notes are incomplete without having attended lectures
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Professor Yamin Ahmad, Business Cycles – ECON 402
What is a Business Cycle?
• Burns & Mitchell (1946) have 4 phases that transition
from one to the other: Prosperity
 Crisis
 Depression
 Revival
• Frisch’s ([1933] 1965) Pendulum
 Distinguish between impulses (arising from random shocks)
and the propagation of these shocks.
Note: These lecture notes are incomplete without having attended lectures
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Professor Yamin Ahmad, Business Cycles – ECON 402
What is a Business Cycle?
• Lucas (1977): An alternative way to view the business
cycle
 Business cycle regularities: “comovements of the deviations
from trend in different aggregative time series”
 Defines the business cycle as: “movements about trend in
gross national product”
 Trend-Cycle decomposition
• Kydland and Prescott’s (1990) contribution:
 Explicit modeling of the trend
 View the trend as the steady state level of the particular
variable of interest (- coming out of growth theory)
Note: These lecture notes are incomplete without having attended lectures
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Professor Yamin Ahmad, Business Cycles – ECON 402
Guidelines for modeling the trend
Kydland and Prescott (1990) use the following guidelines:
• Trend component for real GNP should be approximately the curve that
students of business cycles would draw through a time series plot of
this time series
• The trend of a given time series should be a linear transformation of
that time series, and this transformation should be the same for all
series.
• Lengthening the sample period should not significantly alter the value
of the deviations at a given date, except possibly near the end of the
original sample.
• The scheme should be well defined, judgment free, and cheaply
reproducible
Note: These lecture notes are incomplete without having attended lectures
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Professor Yamin Ahmad, Business Cycles – ECON 402
Trend Cycle Decomposition
• Let yt for t = 1,2,…,T represent a time series, denoted by the (natural)
log of the variable, unless the variable is a share
• The trend component, tt for t = 1,2, …, T is one that minimizes:
  y t 
T
t 1
t
t
2
 l t 2 t t 1  t t   t t  t t 1 
T
Sum of squared
Deviations
(Cyclical component)
2
Sum of squared Trend
components second differences
• First order conditions for this convex minimization problem are linear
and can be solved for tt.
• Kydland and Prescott (1990) find l = 1600 to be reasonable for the
quarterly data that they use.
Note: These lecture notes are incomplete without having attended lectures
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Professor Yamin Ahmad, Business Cycles – ECON 402
Data
• Data is quarterly and ranges from 1954 – 1989.
• Data includes components of:
 Production inputs, e.g. labor and capital components
 Income and output components, e.g. consumption,
investment, etc
 Monetary aggregates and the price level
• Having decomposed the data into trend and cyclical
components, Kydland and Prescott examine
comovements in the cyclical components by computing
correlations of variables at different leads and lags.
Note: These lecture notes are incomplete without having attended lectures
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Professor Yamin Ahmad, Business Cycles – ECON 402
Results: Production Inputs
Leads the cycle
Note: These lecture notes are incomplete without having attended lectures
Lags the cycle
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Professor Yamin Ahmad, Business Cycles – ECON 402
Results:
Output and
Income
Components
Note: These lecture notes are incomplete without having attended lectures
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Professor Yamin Ahmad, Business Cycles – ECON 402
Results: Output and Income Shares
Note: These lecture notes are incomplete without having attended lectures
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Professor Yamin Ahmad, Business Cycles – ECON 402
Results: Monetary Aggregates and Price Level
Note: These lecture notes are incomplete without having attended lectures
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Professor Yamin Ahmad, Business Cycles – ECON 402
Summary
• Production components:
 Total hours is procyclical
 Capital stock is acyclical. However appears to lag the cycle
by about a year
 Employment lags the cycle, whilst hours per worker is nearly
contemporaneous with the cycle.
 Real wage appears to be procyclical
Note: These lecture notes are incomplete without having attended lectures
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Professor Yamin Ahmad, Business Cycles – ECON 402
Summary (cont.)
• Output components
 All variables, e.g. Consumption and Investment are highly
procyclical
 One exception: Government purchases are acyclical
 Investment is a lot more volatile than GNP; consumption is
slightly less volatile
• Factor Incomes
 Labor income and capital income are strongly procyclical
 Capital income is highly volatile
Note: These lecture notes are incomplete without having attended lectures
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Professor Yamin Ahmad, Business Cycles – ECON 402
Summary (cont.)
• Monetary Aggregates
 Monetary base does not appear to lead the cycle
 Monetary aggregates appear to be procyclical
 M2 appears to lead the cycle
 Velocity appears to be procyclical
• Price Level
 Prices appear to be fairly strongly countercyclical.
 Also appears to lead the cycle by about half a year.
Note: These lecture notes are incomplete without having attended lectures
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Professor Yamin Ahmad, Business Cycles – ECON 402
Conclusions
• Kydland and Prescott (1990) report statistics, or empirical
regularities that pertain to the business cycle.
• Use data from 1954 to 1989
• Key innovations in this paper are:
 how they decompose a time series into the trend and cyclical
components.
 a characterization of the phase differences of a business cycle
• Some findings are at odds with existing literature, e.g. prices,
real wages and monetary base.
• The remainder conform to predictions of neoclassical theory
Note: These lecture notes are incomplete without having attended lectures
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