Business Cycle Accounting

This paper proposes a simple method for guiding researchers in developing quantitative models of economic fluctuations. We show that a large class of models, including models with various frictions, are equivalent to a prototype growth model with time varying wedges that, at least on face value, look like time-varying productivity, labor taxes, and capital income taxes. We label the time varying wedges as e ciency wedges, labor wedges, and investment wedges. We use data to measure these wedges and then feed them back into the prototype growth model. We then assess the fraction of fluctuations accounted for by these wedges during the great depressions of the 1930s in the United States, Germany, and Canada and in the postwar U.S. business cycles. We find that the e ciency and labor wedges in combination account for essentially all of the declines and subsequent recoveries. Investment wedges play, at best, a minor role. Chari, University of Minnesota and Federal Reserve Bank of Minneapolis; Kehoe, Federal Reserve Bank of Minneapolis and University of Minnesota; McGrattan, Federal Reserve Bank of Minneapolis and University of Minnesota. The authors thank the National Science Foundation for support. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. We propose a simple method for guiding researchers in developing quantitative models of economic fluctuations. Our method has two components: an equivalence result and an accounting procedure. The equivalence result is that a large class of models, including models with various frictions, are equivalent to a prototype growth model with time varying wedges that, at least on face value, look like time-varying productivity, labor taxes, and capital income taxes. For example, we show that an economy in which the technology is constant but input financing frictions vary over time is equivalent to a growth model with time-varying productivity. We show that models with sticky wages or labor unions are equivalent to a growth model with time-varying labor taxes, and a model with investment financing frictions is equivalent to a growth model with time-varying capital income taxes. These examples lead us to label the time varying wedges as e ciency wedges, labor wedges, and investment wedges. Our accounting procedure begins by using the data together with the equilibrium conditions of a prototype growth model to measure the wedges. We then feed the values of these wedges back into the growth model one at a time and in combinations to assess what fraction of the output movements can be attributed to each wedge separately and in combination. (Of course, in a deterministic model, by construction, all three wedges account for all of the observed movements in output.) We apply our method to the great depressions in the 1930s in three countries: the United States, Germany, and Canada and to the 1982 recession in the United States. In all three countries output declined dramatically in the early 1930’s and then recovered to varying extents in the late 1930’s. In the United States and Canada the recovery was slow while in Germany the recovery was rapid. Our accounting yields clear results for all three countries. The e ciency wedge alone accounts for roughly half of the decline in output in all three countries. This wedge, however, accounts for at most a third of the decline in labor. The labor wedge alone alone accounts for one third to one half of the decline in output and accounts for essentially all of the decline in labor. The e ciency and labor wedges in combination account for essentially all of the fall and subsequent recovery in output. These wedges in combination also account well for the decline and recovery in labor and investment. These findings lead us to conclude that investment wedges play, at best, a minor role in these depressions. For the 1982 recession of the United States we find that the e ciency wedge alone accounts for most of the decline and recovery in output, but misses some of the downturn in labor. The labor wedge alone produces hardly any fluctuations in output but captures some of the downturn in labor. Together they capture the downturn in output well. Relative to the great depressions we find that the labor wedge plays a much smaller role. As in the great depressions we find that there is little room for investment wedges to play much of a role. The goal of this business cycle accounting is to guide researchers in developing detailed models with the kinds of frictions that can deliver the quantitatively relevant types of observed wedges in the prototype economy. For example, both the sticky wage and cartelization theories are promising explanations of the observed labor wedges, while the simplest models of investment financing frictions are not. Theorists attempting to develop models of particular channels through which shocks cause large fluctuations in output will benefit from asking whether those channels are consistent with the fluctuations in wedges that we document. We emphasize that we view our method as a useful first step in guiding the construction of detailed models. In building detailed models, theorists face hard choices on where to introduce frictions in markets. Our method is intended to help in making those choices. Our method is not a procedure for testing particular detailed models. If a detailed model is already at hand, then presumably it makes sense to confront that model directly with the data. We also emphasize that our method is not well suited to identifying the source of primitive shocks. It is intended to help us understand the mechanisms through which such shocks lead to economic fluctuations. For example, many economists agree that monetary