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Separating the Business Cycle from Other Economic Fluctuations

  • Robert E. Hall

Macroeconomists%u2014%u2014especially those studying monetary policy%u2014%u2014often view the business cycle as a transitory departure from the smooth evolution of a neoclassical growth model. Important ideas contributed by Friedman, Lucas, and the developers of the sticky-price macro model generate this type of aggregate behavior. But the real-business cycle model shows that the neoclassical model implies anything but smooth growth. A purely neoclassical model, devoid of anything resembling a business cycle in the sense of transitory departures from neoclassical equilibrium, nevertheless explains most of the volatility of GDP growth at all frequencies. Monetary policymakers looking to a neoclassical model to provide the neutral levels of key variables-potential GDP, the natural rate of unemployment, and the equilibrium real interest rate, need to solve a complicated and controversial model to find these constructs. They cannot take average or smoothed values of actual data to find them. Further, low-frequency movements of unemployment suggest a failure of the basic idea that departures from the neoclassical equilibrium are transitory. I discuss new theories of the labor market capable of explaining the low-frequency movements of unemployment. I conclude that monetary policymakers should not try to discern neutral values of real variables. Some branches of modem theory do not support the concepts of potential GDP, the natural rate of unemployment, and the equilibrium real interest rate. Even the theories that do support the concepts suggest that measurement in real time is impractical.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 11651.

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Date of creation: Oct 2005
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Publication status: published as The Greenspan Era: Lessons for the Future, proceedings of the Federal Reserve Bank of Kansas City Symposium, August 2005, pp. 133-179.
Handle: RePEc:nbr:nberwo:11651
Note: EFG
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  1. Pissarides, Christopher A, 1985. "Short-run Equilibrium Dynamics of Unemployment Vacancies, and Real Wages," American Economic Review, American Economic Association, vol. 75(4), pages 676-90, September.
  2. Robert E. Hall, 2001. "The Stock Market and Capital Accumulation," American Economic Review, American Economic Association, vol. 91(5), pages 1185-1202, December.
  3. Douglas Staiger & James H. Stock & Mark W. Watson, 1996. "How Precise are Estimates of the Natural Rate of Unemployment?," NBER Working Papers 5477, National Bureau of Economic Research, Inc.
  4. John Kennan, 2010. "Private Information, Wage Bargaining and Employment Fluctuations," Review of Economic Studies, Oxford University Press, vol. 77(2), pages 633-664.
  5. Robert E. Hall & Paul R. Milgrom, 2007. "The Limited Influence of Unemployment on the Wage Bargain," Levine's Bibliography 321307000000000135, UCLA Department of Economics.
  6. Barro, Robert J., 1977. "Long-term contracting, sticky prices, and monetary policy," Journal of Monetary Economics, Elsevier, vol. 3(3), pages 305-316, July.
  7. Kydland, Finn E & Prescott, Edward C, 1982. "Time to Build and Aggregate Fluctuations," Econometrica, Econometric Society, vol. 50(6), pages 1345-70, November.
  8. P. Diamond, 1980. "Aggregate Demand Management in Search Equilibrium," Working papers 268, Massachusetts Institute of Technology (MIT), Department of Economics.
  9. Athanasios Orphanides & Simon van Norden, 1999. "The reliability of output gap estimates in real time," Finance and Economics Discussion Series 1999-38, Board of Governors of the Federal Reserve System (U.S.).
  10. Hansen, Lars Peter & Singleton, Kenneth J, 1983. "Stochastic Consumption, Risk Aversion, and the Temporal Behavior of Asset Returns," Journal of Political Economy, University of Chicago Press, vol. 91(2), pages 249-65, April.
  11. Mortensen, Dale T & Pissarides, Christopher A, 1994. "Job Creation and Job Destruction in the Theory of Unemployment," Review of Economic Studies, Wiley Blackwell, vol. 61(3), pages 397-415, July.
  12. Mortensen, Dale T, 1982. "Property Rights and Efficiency in Mating, Racing, and Related Games," American Economic Review, American Economic Association, vol. 72(5), pages 968-79, December.
  13. Robert E. Hall, 2005. "Employment Fluctuations with Equilibrium Wage Stickiness," American Economic Review, American Economic Association, vol. 95(1), pages 50-65, March.
  14. Robert Shimer, 2005. "The Cyclical Behavior of Equilibrium Unemployment and Vacancies," American Economic Review, American Economic Association, vol. 95(1), pages 25-49, March.
  15. Shiller, Robert J, 1981. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," American Economic Review, American Economic Association, vol. 71(3), pages 421-36, June.
  16. Lucas, Robert Jr., 1972. "Expectations and the neutrality of money," Journal of Economic Theory, Elsevier, vol. 4(2), pages 103-124, April.
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