Great Ratios, Balanced Growth and Stochastic Trends: Evidence for the Euro Area

Following Kydland and Prescott's (1982) seminal paper, a key question that has been debated widely remains, `Are business cycles mainly the result of permanent shocks to productivity?' This paper attempts to answer this question in the context of the Euro area economy as a whole, given current efforts to understand the design of Euro-wide policies. To help shed light on the preceding question for the Euro area a common trends model is utilised, allowing for the study of growth and business cycles phenomena in a joint framework. This paper imposes a long-run restriction implied by a large class of Real Business Cycle (RBC) models - identifying permanent productivity shocks as innovations to a common stochastic trend in output, consumption and investment - to provide evidence on the role of balanced growth shocks for the Euro area business cycle. This approach is given further credibility by the finding of stationary great ratios, justifying the use of exogenous growth models in examining the significance of productivity shocks on real output fluctuations for the Euro area. The results are broadly supportive of standard RBC theory, with the finding that up to 60% of transitory fluctuations are caused by exogenous permanent productivity shocks. The model further finds that productivity shocks have useful explanatory power in illuminating certain macroeconomic historical episodes, in contrast to monetary and inflation shocks, which appear to have played a relatively minor role in driving output fluctuations.