Putting the cycle back into business cycle analysis

Abstract

Are business cycles mainly a response to persistent exogenous shocks, or do they instead reflect a strong endogenous mechanism which produces recurrent boom-bust phenomena? In this paper we present new evidence in favour of the second interpretation and, most importantly, we highlight the set of key elements that influence our answer to this question. In particular, when adopting our most preferred estimation framework, we find support for the somewhat extreme notion that business cycles may be generated by stochastic limit cycle forces; that is, we find support for the notion that business cycles may primarily reflect an endogenous propagation mechanism buffeted only by temporary shocks. The three elements that tend to favour this type of interpretation of business cycles are: (i) slightly extending the frequency window one associates with business cycle phenomena, (ii) allowing for strategic complementarities across agents that arise due to financial frictions, and (iii) allowing for a locally unstable steady state in estimation. We document the sensitivity of our findings to each of these elements within the context of an extended New Keynesian model with real-financial linkages.

The ADEMU Working Paper Series is being supported by the European Commission Horizon 2020 European Union funding for Research & Innovation, grant agreement No 649396.