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

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.