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The role of real and nominal variables in defining business cycles: dynamic properties of a hybrid model - an alternative view

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  • Chirwa, Themba G.

Abstract

The paper provides an alternative view to the Real and New Keynesian business cycle theories. The paper focuses on the combination of both real and nominal variables in explaining the cyclical movements of business cycles. We propose using Vector Autoregressive (VAR) technique on the production function approach in order to empirically assess the relative importance of both real and nominal variables in defining the shape of a business cycle (or output gap). An economy-specific variable (inflation) is introduced in the production function and is used to control the severity, persistence and magnitude of a given real shock. The model employed is tested in four countries namely: United States of America, United Kingdom, Canada and Germany. The results show that indeed real and nominal variables play an important and major role in explaining movements in business fluctuations. The bulk of impulse responses given a real shock to the output gap may also be attributed to movements in nominal variables mainly as a result of inflationary movements. This economy specific parameter conveys the same message that Ragnar Frisch hypothesized in 1933 based on his ‘rocking-horse theory’. The paper thus provides policy makers to identify key choice variables to use when reducing the impact of shocks in a given economy within a specified period of time.

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File URL: http://mpra.ub.uni-muenchen.de/18949/
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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 18949.

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Date of creation: Oct 2009
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Handle: RePEc:pra:mprapa:18949

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Related research

Keywords: Business cycle; Vector autoregression; Impulse and propagation mechanisms; Hodrick-Prescott filter; Production function approach.;

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  1. Laidler, D., 1991. "The Cycle Before New-Classical Economies," UWO Department of Economics Working Papers 9115, University of Western Ontario, Department of Economics.
  2. Sergio Rebelo, 2005. "Real Business Cycle Models: Past, Present, and Future," NBER Working Papers 11401, National Bureau of Economic Research, Inc.
  3. N. Gregory Mankiw & Ricardo Reis, 2001. "Sticky Information Versus Sticky Prices: A Proposal to Replace the New Keynesian Phillips Curve," Harvard Institute of Economic Research Working Papers 1922, Harvard - Institute of Economic Research.
  4. Johansen, Soren, 1995. "Likelihood-Based Inference in Cointegrated Vector Autoregressive Models," OUP Catalogue, Oxford University Press, number 9780198774501.
  5. David Colander, 1992. "New Keynesian Economics in Perspective," Eastern Economic Journal, Eastern Economic Association, vol. 18(4), pages 438-448, Fall.
  6. Rod Cross, 2000. "Hysteresis and Emu," Metroeconomica, Wiley Blackwell, vol. 51(4), pages 367-379, November.
  7. Ossama Mikhail, 2004. "No More Rocking Horses: Trading Business-Cycle Depth for Duration Using an Economy-Specific Characteristic," Macroeconomics 0402026, EconWPA.
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