Federal Reserve Bank of Minneapolis Quarterly Review | Macro Paper Warehouse

Business Cycles: Real Facts and a Monetary Myth

This 1990 Federal Reserve Bank of Minneapolis Quarterly Review paper argues that reporting business cycle facts without first assuming the data are generated by some probability model is a legitimate scientific activity, contrary to Koopmans’s (1947) “measurement without theory” critique of Burns and Mitchell, and the authors use established neoclassical growth theory only to select which facts to report and how to organize them. Following Lucas (1977), they define business cycles as deviations of real GNP (and other aggregates) from trend, and they complete Lucas’s definition by specifying an explicit, judgment-free detrending procedure (the Hodrick-Prescott filter) to compute that trend. Reporting these statistics for the U.S. economy over 1954-1989, they find that several widely held beliefs about postwar business cycles are myths: the price level, measured by either the implicit GNP deflator or the CPI, has been countercyclical rather than procyclical since the Korean War; the monetary base and M1 do not lead the cycle; and the real wage is procyclical, not countercyclical or acyclical as the literature (including Summers 1986) had claimed. They also report that investment expenditures are several times more volatile than nondurable consumption, that labor hours are almost as volatile as GNP while capital is smooth and lags the cycle, and that M2 (and especially the non-M1 component of M2) shows some evidence of leading the cycle. The paper concludes that any future business cycle theory in which procyclical prices are central “is doomed to failure,” and that introducing money and credit into growth theory to account for both the monetary and real facts remains an open problem.

Response to a Skeptic

This 1986 Federal Reserve Bank of Minneapolis Quarterly Review piece is Edward Prescott’s direct reply, in the same issue, to Lawrence Summers’s “Some Skeptical Observations on Real Business Cycle Theory.” Prescott welcomes the challenge as part of normal scientific process but argues Summers’s specific objections fail: on prices, Prescott says real business cycle analysts do use the relevant relative prices (the real wage and the rental price of capital) and that their behavior in the model “conforms with that observed”; on technology shocks, he says the relevant finding is not a few large, identifiable shocks but small shocks every period, consistent with a long tradition (Slutzky 1927) of cyclical behavior from low-order stochastic difference equations. On parameters, Prescott defends the one-third market-time share and 4 percent real-interest-rate assumptions using Ghez and Becker’s (1975) time-use data and the return on business-sector tangible capital rather than Treasury bills, and argues that Rogerson’s (1984) and Hansen’s (1985) indivisible-labor/employment-lotteries theory resolves the apparent conflict between small micro-level and large macro-level labor-supply elasticities, making the specific value of the micro intertemporal-substitution parameter largely moot for the model’s aggregate predictions. On Summers’s labor-hoarding critique, Prescott argues the Fay-Medoff survey question was too ambiguous to measure cyclicality and that properly quality-adjusting hours worked (effective units of labor, following Kydland 1984) would make measured productivity more, not less, cyclically volatile than currently measured. Prescott closes by arguing Summers has not challenged the use of competitive theory and the neoclassical growth framework per se — which Summers himself uses elsewhere — but only the unexpected magnitude of its implied role for technology shocks, and that both authors agree current labor-input measurement is imprecise, which is itself evidence that “theory is ahead of business cycle measurement.”

Some Monetary Facts

This 1995 Federal Reserve Bank of Minneapolis Quarterly Review paper by George T. McCandless Jr. and Warren E. Weber examines three long-run monetary facts drawn from a cross-section of 110 countries over 1960-1990 (IMF International Financial Statistics data, up to 30 years of geometric-average annual growth rates per country), using three definitions of the money supply (M0, M1 and M2) and two robustness subsamples (21 OECD countries and 14 Latin American countries). They find, first, a high, almost-unity correlation between the growth rate of the money supply and the rate of inflation that holds for all three money definitions and across the full sample and both subsamples (correlation coefficients of 0.89 or higher, closest to one for the broader M1 and M2 aggregates); second, no correlation between the growth rates of money and real output in the full sample or the Latin American subsample, but a positive and economically non-trivial correlation (0.51 to 0.71, with a regression slope of roughly 0.1) in the OECD subsample alone; and third, essentially no correlation between inflation and real-output growth in the full sample once a single outlier (Nicaragua, which combined -12% output growth with 52% inflation during its civil war) is excluded, a finding that again holds up, though not always at conventional significance, across both subsamples. The authors argue that, to the extent these long-run correlations reflect causal relationships, central banks can expect to influence long-run inflation by adjusting money growth but cannot translate that into precise short-run inflation targets, since realized inflation also depends on real output and velocity growth that are difficult to predict, and that the absence of a long-run money-output correlation suggests monetary policy’s long-run effect on real activity is essentially nil, though the data are silent on any short-run real effects.

Some Skeptical Observations on Real Business Cycle Theory

This 1986 Federal Reserve Bank of Minneapolis Quarterly Review piece, responding directly to Edward Prescott’s companion article “Theory Ahead of Business Cycle Measurement” in the same issue, argues that real business cycle (RBC) models of the type Prescott surveys “have nothing to do with the business cycle phenomena observed in the United States or other capitalist economies.” Summers raises four objections: the model’s key parameters (the time discount rate implying a 4 percent real interest rate, and the one-third household time-share devoted to market work) are not, in his reading of the same micro evidence Prescott cites, well tied down; there is no independent evidence for the technology shocks the model treats as the sole driving force, and postwar productivity declines are better explained by labor hoarding than by technological regress; the model is “price-free” in that it never confronts data on real wages, interest rates, or asset returns with its predictions, which Summers says have fared poorly elsewhere; and the model entirely omits breakdowns of the exchange mechanism — such as credit-market disruptions — which Summers argues are central to the largest historical fluctuations, including the Great Depression. He closes by cautioning against a “lengthy professional detour into the analysis of stochastic Robinson Crusoes” and suggesting credit-crunch accounts of postwar recessions as a more promising direction. The piece is explicitly framed as a skeptical, polemical assessment rather than a formal rebuttal, and Prescott’s direct reply appears in the same Quarterly Review issue immediately following it.