Money, Prices, Interest Rates and the Business Cycle

The mechanisms governing the relationship of money, prices and interest rates to the business cycle are the most studied and most disputed topics in macroeconomics. In this paper, we first document key empirical aspects of this relationship. We then ask how well three benchmark rational expectations macroeconomic models--real business cycle model, a sticky price model and a liquidity effect model--account for these central facts. While the models have diverse successes and failures, none can account for the fact that real and nominal interest rates are 'inverted leading indicators' of real economic activity. That is, none of the models captures the post-war U.S. business cycle fact that a high real or nominal interest rate in the current quarter predicts a low level of real economic activity two to four quarters in the future. Copyright 1996 by MIT Press.