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Money, prices, interest rates and the business cycle

  • Robert G. King
  • Mark W. Watson

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.

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Paper provided by Federal Reserve Bank of Chicago in its series Working Paper Series, Macroeconomic Issues with number 95-10.

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Date of creation: 1995
Date of revision:
Handle: RePEc:fip:fedhma:95-10
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  1. King, Robert G. & Plosser, Charles I. & Rebelo, Sergio T., 1988. "Production, growth and business cycles : II. New directions," Journal of Monetary Economics, Elsevier, vol. 21(2-3), pages 309-341.
  2. Robert G. King & Charles I. Plosser & James H. Stock & Mark W. Watson, 1987. "Stochastic Trends and Economic Fluctuations," NBER Working Papers 2229, National Bureau of Economic Research, Inc.
  3. King, Robert G. & Plosser, Charles I. & Rebelo, Sergio T., 1988. "Production, growth and business cycles : I. The basic neoclassical model," Journal of Monetary Economics, Elsevier, vol. 21(2-3), pages 195-232.
  4. Robert S. Chirinko, 1993. "Business fixed investment spending: a critical survey of modeling strategies, empirical results, and policy implications," Research Working Paper 93-01, Federal Reserve Bank of Kansas City.
  5. Soderlind, Paul, 1994. "Cyclical Properties of a Real Business Cycle Model," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 9(S), pages S113-22, Suppl. De.
  6. Gray, Jo Anna, 1978. "On Indexation and Contract Length," Journal of Political Economy, University of Chicago Press, vol. 86(1), pages 1-18, February.
  7. King, Robert G & Plosser, Charles I, 1984. "Money, Credit, and Prices in a Real Business Cycle," American Economic Review, American Economic Association, vol. 74(3), pages 363-80, June.
  8. Fuerst, Timothy S., 1992. "Liquidity, loanable funds, and real activity," Journal of Monetary Economics, Elsevier, vol. 29(1), pages 3-24, February.
  9. Blanchard, Olivier Jean & Kahn, Charles M, 1980. "The Solution of Linear Difference Models under Rational Expectations," Econometrica, Econometric Society, vol. 48(5), pages 1305-11, July.
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