What’s Real About the Business Cycle?

In part, this shift in the profession’s conception of what needs to be explained about business fluctuations reflects a desire to integrate the determinants of long-run economic growth and the causes of short-run economic downturns within a single unified theory of aggregate economic performance. Since improvements in overall productivity are widely acknowledged to be one of the key factors driving long-run growth, and since such improvements cannot reasonably be expected to occur at a constant rate over time, it is natural to explore the possibility that variation over time in the rate of technological progress could be a primary cause of variation over time in the level of economic activity. Brock and Mirman (1972) were the first to incorporate stochastic variation in the rate of technical progress into a neoclassical growth model, though they clearly intended this as a model of long-run growth rather than a realistic description of short-run fluctuations. Kydland and Prescott (1982) later took the much bolder step of proposing that this class of models might explain variations in economic activity at all freWHAT IS THE BUSINESS CYCLE? The term “cycle” is used to describe a process that moves sequentially between a series of clearly identifiable phases in a recurrent or periodic fashion. Economists of the nineteenth and early twentieth centuries were persuaded that they saw such a pattern exhibited in the overall level of economic activity and enthusiastically sought to characterize the observed regularities of what came to be known as the “business cycle.” The most systematic and still-enduring summaries of what seems to happen during the respective phases were provided by Mitchell (1927, 1951) and Burns and Mitchell (1946). The expression “business cycle theory” remains in common usage today, even though, in most of the modern models that wear the label, there in fact is no business cycle in the sense just described. These are models of economic fluctuations, to be sure, but they do not exhibit clearly articulated phases through which the economy could be said to pass in a recurrent pattern. This paper argues that a linear statistical model with homoskedastic errors cannot capture the nineteenth-century notion of a recurring cyclical pattern in key economic aggregates. A simple nonlinear alternative is proposed and used to illustrate that the dynamic behavior of unemployment seems to change over the business cycle, with the unemployment rate rising more quickly than it falls. Furthermore, many but not all economic downturns are also accompanied by a dramatic change in the dynamic behavior of short-term interest rates. It is suggested that these nonlinearities are most naturally interpreted as resulting from short-run failures in the employment and credit markets and that understanding these short-run failures is the key to understanding the nature of the business cycle.