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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.

Suggested Citation

  • Chirwa, Themba G., 2009. "The role of real and nominal variables in defining business cycles: dynamic properties of a hybrid model - an alternative view," MPRA Paper 18949, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:18949
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    File URL: https://mpra.ub.uni-muenchen.de/18949/1/MPRA_paper_18949.pdf
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    References listed on IDEAS

    as
    1. S. Rebelo., 2010. "Real Business Cycle Models: Past, Present, and Future," VOPROSY ECONOMIKI, N.P. Redaktsiya zhurnala "Voprosy Economiki", vol. 10.
    2. N. Gregory Mankiw, 1985. "Small Menu Costs and Large Business Cycles: A Macroeconomic Model of Monopoly," The Quarterly Journal of Economics, Oxford University Press, vol. 100(2), pages 529-538.
    3. N. Gregory Mankiw & Ricardo Reis, 2002. "Sticky Information versus Sticky Prices: A Proposal to Replace the New Keynesian Phillips Curve," The Quarterly Journal of Economics, Oxford University Press, vol. 117(4), pages 1295-1328.
    4. Rod Cross, 2000. "Hysteresis and Emu," Metroeconomica, Wiley Blackwell, vol. 51(4), pages 367-379, November.
    5. Johansen, Soren, 1995. "Likelihood-Based Inference in Cointegrated Vector Autoregressive Models," OUP Catalogue, Oxford University Press, number 9780198774501.
    6. David Laidler & Ben S. Bernanke (ary), 1992. "The cycle before new-classical economics," Proceedings, Federal Reserve Bank of St. Louis, pages 85-117.
    7. Ossama Mikhail, 2004. "No More Rocking Horses: Trading Business-Cycle Depth for Duration Using an Economy-Specific Characteristic," Macroeconomics 0402026, EconWPA.
    8. David Colander, 1992. "New Keynesian Economics in Perspective," Eastern Economic Journal, Eastern Economic Association, vol. 18(4), pages 438-448, Fall.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

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

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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