Economics 314 Coursebook, 2008 Jeffrey Parker 13 EMPIRICAL EVIDENCE ON AGGREGATE SUPPLY MODELS AND BUSINESS CYCLES Chapter 13 Contents A. Topics and Tools .................................................................................2 B. Basic Empirical Facts of Business Cycles............................................2 Length and magnitude of cycles..........................................................................3 Behavior of GDP components over the cycle........................................................3 Cyclical behavior of other variables ....................................................................4 C. Real vs. Keynesian Interpretations of Cycles......................................5 The basic case for RBC models ...........................................................................6 Productivity shocks, wages, and labor input ........................................................9 Microeconomic evidence on intertemporal substitution.......................................11 Direct evidence that supply shocks cause cycles ...................................................12 The basic case for Keynesian models..................................................................15 Direct evidence that demand shocks cause cycles.................................................17 D. Are Output Shocks Permanent? ........................................................20 Nelson and Plosser’s test for reversion to trend..................................................21 Studies not based on unit root tests ...................................................................21 E. Interpreting the Cyclicality of Prices and Inflation .........................22 F. Interpreting Procyclical Labor Productivity ....................................25 Explaining procyclical productivity without technology shocks ............................25 Increasing returns to scale and procyclical productivity ......................................26 Evidence on labor hoarding and job hoarding ...................................................28 Evidence on the workweek of capital.................................................................29 G. Direct Estimation of the Sources of Cycles ......................................31 Blanchard and Quah.......................................................................................31 H. Empirical Tests of the Lucas Aggregate Supply Model....................3713 — 2 International evidence on the slope of the AS curve ...........................................37 Evidence from hyperinflations..........................................................................39 Tests of policy ineffectiveness ............................................................................40 I. Direct Evidence of Price and Wage Stickiness .................................42 Pitfalls in testing for price and wage stickiness..................................................42 Data on transaction prices ...............................................................................43 Studies using micro-data underlying price indexes............................................45 J. Why Are Prices Sticky?......................................................................47 Survey evidence on the causes of price stickiness.................................................47 Evidence on menu costs from supermarket data ................................................49 The nickel Coke ..............................................................................................51 Administrative costs of price adjustment...........................................................52 K. Further Evidence on Recent Models .................................................53 L. Works Cited in Text...........................................................................55 A. Topics and Tools The literature testing the sources of business-cycle fluctuations and the na-ture of aggregate supply is voluminous. This chapter describes a few selected studies on a few of the major topics. In particular, the literature examining vari-ants of the real business cycle model is enormous and only a tiny fragment is pre-sented here. Many basic tools of time-series econometrics are used in the studies reviewed here. You don’t need to understand all the details of the statistical models to read this summary, but a good background in econometrics would be helpful for read-ing the source papers. B. Basic Empirical Facts of Business Cycles Some aspects of business cycles are subject to heated dispute, but many pat-terns are unambiguous regardless of the country or time period one examines. In addition to Stock and Watson (1999), which focuses on the United States, you may wish to examine the overview of evidence for the United States, Europe,13 — 3 and Japan presented in Chapter 14 of the macroeconomics text by Burda and Wyplosz (1998). Much of the discussion presented here is based on the results reported by Burda and Wyplosz. Length and magnitude of cycles Burda and Wyplosz present evidence in their Table 14.1 on the length and severity of business-cycle fluctuations in six countries from 1970 to 1994. The average peak-to-peak length of the business cycle varies from 5.5 years in the United States to just over 9 years in Japan. This is somewhat longer than the typical business cycle before 1970. Within the post-1970 sample there is consid-erable variation in the length of cycles: from one as short as 6 quarters in the United States to 12-year cycles recorded in France and Germany. The average percentage deviation of real GDP at the peak or trough from its level at the midpoint of the cycle is between 2% and 3.5% in these six countries. Thus, although business cycles still receive a lot of attention, recent cycles have been far less severe than the 30% decline in output that occurred in the United States from 1929 to 1933.1 Behavior of GDP components over the cycle All of the components of private spending tend to be procyclical. Consump-tion is strongly correlated with income over the cycle, but tends to be quite a lot smoother. Since economic theory tells us that households would like to smooth their consumption, this is not surprising. Investment is the most volatile of the components of expenditures. Invest-ment bears a disproportionate share of the decline in recessions and experiences the strongest relative expansion