Business Cycles in International Historical...

Business Cycles in InternationalHistorical Perspective

Susanto Basu and Alan M. Taylor

B usiness cycle models seek to answer the question of why economies gothrough cycles of recession and recovery, or boom and bust. Any theory ofthe business cycle makes two sorts of claims: what shocks are most impor-

tant in disturbing the economy and what economic structure is necessary forpropagating these shocks. For example, one common explanation of businesscycles begins with monetary shocks and then seeks to explain why monetary shocksare not purely neutral, as neoclassical theory would have it, and instead have realeffects, at least in the short term. Early models in this vein were often implicitly orexplicitly based on the proposition that markets do not clear continuously. Earlyequilibrium “real business cycle” theories instead emphasized the importance ofreal shocks, especially to technology, which may cause socially efficient fluctuationseven when markets are always in equilibrium. More recent models have attemptedto marry the equilibrium approach to macroeconomics with the substantive Key-nesian ideas that money is not neutral and that economic fluctuations are costly.New Keynesian theories of the business cycle admit the possibility of a number ofeconomic shocks, including monetary and technology shocks, but then focus onexplaining how nominal price rigidities within the economy can turn these shocksinto recessions or booms. Other models show that business cycles driven by Key-nesian “animal spirits” are consistent with rigorous microfoundations and rationalexpectations.

Seeking empirical evidence for and against these various approaches, we turnbusiness cycle theories loose on perhaps the greatest macroeconomic laboratory

y Susanto Basu is Associate Professor of Economics, University of Michigan, Ann Arbor,Michigan. Alan M. Taylor is Assistant Professor of Economics, Northwestern University,Evanston, Illinois. Basu is a Research Associate and Taylor is a Faculty Research Fellow,National Bureau of Economic Research, Cambridge, Massachusetts. Their e-mail addressesare ^[email protected]& and ^[email protected]&, respectively.

Journal of Economic Perspectives—Volume 13, Number 2—Spring 1999—Pages 45–68

available: the extant record of macroeconomic historical statistics for a broadcross-section of countries since the late 19th century. We have annual time-seriesdata running from circa 1870 to the present on output, prices, real wages, exchangerates, total consumption (public plus private), investment, and the current accountfor 15 countries.1 Over this time frame, this is the largest such panel of data everstudied in terms of country coverage.

We will further focus our discussion by dividing the last 130 years into four timeperiods that, not coincidentally, echo the usual division of this time frame into fourdistinct international monetary regimes (Eichengreen, 1996; Obstfeld and Taylor,1999). The first period from about 1870 up to 1914 represents the time when muchof the world economy worked according to the classical gold standard. This systemwas for most countries a stable and credible regime, characterized by fixed ex-change rates and monetary discipline, and it facilitated the integration of globalcapital markets (Eichengreen, 1996; Eichengreen and Flandreau, 1996; Bordo andKydland, 1995; Bordo and Rockoff, 1996; Edelstein, 1982). In the second period,from 1919 to 1939 (we omit both world wars from our sample), this well-integratedglobal economy was destroyed; it went from globalized to almost autarkic in thespace of a few decades. Capital controls became widespread, capital flows wereminimal, and international investment was regarded with suspicion (Eichengreen,1992; Temin, 1989). In the third period, the Bretton Woods era from 1945 to 1971,an attempt to rebuild the global economy took shape, and global trade and capitalflows increased. However, exchange rates remained largely fixed by internationaltreaty and the design of the International Monetary Fund allowed capital controlsas a means for governments to prevent currency crises and runs, and to providescope for activist monetary policy (Bordo and Eichengreen, 1993; Eichengreen,1996). The fourth period, the era of floating exchange rates, has lasted from theearly 1970s to the present. Floating rates meant that capital controls were no longerneeded: shifts in market sentiment now resulted in exchange rate shifts rather thanpressure for a flow of capital (Obstfeld and Rogoff, 1995; Eichengreen, 1996; IMF,1997). This generally encouraged the integration of capital markets, althoughimportant setbacks to that global movement of capital were seen in the developingeconomy debt crisis of the early 1980s and in the emerging markets financial crisesof 1997–98.

Dividing the time period according to these monetary regimes represents ourjudgement that although goods and labor markets evolved, too, the change incapital mobility probably deserves the greatest scrutiny as a factor affecting businesscycle fluctuations. Indeed, such a focus on capital-market shocks dominates most of

1 The countries are: Argentina, Australia, Canada, Denmark, Finland, France, Germany, Italy, Japan,Netherlands, Norway, Spain, Sweden, United Kingdom, United States. This empirical approach is anextension of Backus and Kehoe (1992). We owe many debts to scholars who helped us collate the data,especially Michael Bordo. Bergman, Bordo and Jonung (1998) performed a similar exercise; unlikethem, we also examine the cyclicality of real wages, drawing on the historical real wage databaseassembled by Williamson (1995, and more recent revisions). For more details of the data so assembledsee Obstfeld and Taylor (1999). A summary of the data sources is contained in a longer, working-paperversion of the present article. That paper, and the data, are available upon request from the authors.

46 Journal of Economic Perspectives

the specialist literature just as it does most popular writing—past and present—discussing the impact of the global economy on local economies in crisis ordepression.

A variety of historical data strongly support the division of economic historyinto these four segments (Obstfeld and Taylor, 1999, ch. 2). For example, from1870 to 1914, the average size of international capital flows in our 15 countries, asmeasured by current account deficits, was often as high as 4-5 percent of nationalincome before World War I. Foreign assets rose from 7 percent of world GDP in1870 to just under 20 percent in the years from 1900–14. As global capital marketsintegrated, interest rates in different countries clustered at similar levels. Duringthe period from 1919–1939, international capital flows diminished in the 1920s andwere typically less than 2 percent of national income in the late 1930s. Foreignassets were only 8 percent of world output by 1930 and just 5 percent in 1945. Asglobal capital markets disintegrated, the dispersion of real interest rates doubled inthe 1920s (Lothian, 1985). During the third period, from 1945 through the 1960s,the size of international capital flows declined to an all-time low, around 1 percentof national income. Only during the floating exchange rate period of the late 1970sand 1980s have international capital flows increased, although the annual flows arestill not yet to levels comparable to those of a century ago. Today, gross foreignassets have risen again, to about 50 percent of world GDP. As global capital marketshave stabilized and reintegrated, the dispersion of real interest rates has returnedto its pre-1914 levels.

Thus, our approach in this paper is to see what an international and historicalperspective has to say about the sources and structures of business cycles. Oneadvantage of this approach is that a robust and useful theory of business cyclesshould be able to account for the patterns seen in the long-run data for manycountries. This ought to be a more discriminating test than, say, applying onetheory to selected years for one country. Moreover, the division into four differenttime periods does not just reflect the obvious differences in monetary regimes—each regime also restricts the set of possible economic shocks and propagationmechanisms while allowing others, and thus affects the behavior of many nonmon-etary economic variables over the business cycle. The analysis of business cycles atthe global level forces us to confront the open-economy extensions of all thetheories and the extent to which such theories can then fit into the historical recordof an evolving global economy.

We will not seek to build up a particular model of business cycles and thenstrive to defend it. Instead, we will search for regularities in the historical andinternational data in an attempt to whittle down the set of acceptable business cyclemodels. Our empirical evidence starts with a look at the behavior of the macro-economic aggregates during the four time periods—like income, consumption,investment, the current account, and the price level—both as a way of becomingacquainted with the data and to address the question of whether business cycleshave become less volatile over time. We then lay out a set of issues on whichbusiness cycle theory must take a stand and then examine cross-country data fromseveral historical periods that point to some answers. We explore evidence that

Susanto Basu and Alan M. Taylor 47

monetary shocks are not neutral in their effect on the economy, and then considerwhether this is because nominal prices, or wages, are slow to adjust. We considerwhether the labor market clears, at least to a first approximation, and find some-what ambivalent results. We then debate whether we can continue to think ofbusiness cycles in closed-economy settings, or if the explanations of the sources ofeconomic shocks and the structures that may propagate them are more plausiblyexplored in an open-economy model. Finally, based on these discussions of thecharacteristics of business cycles, we offer some preliminary thoughts about whatsorts of business cycle models we believe will offer the most fertile approach forfuture research.

Patterns of Macroeconomic Aggregates

The first major question in all historical accounts of the evolution of thebusiness cycle is whether the cycle has become more or less volatile over time.Controversy has raged over whether the postwar period has witnessed a diminutionof volatility, perhaps reflecting institutional developments and the successful ap-plication of macro-management policies, or whether the business cycles acrossnations are no less volatile than they were during the late 19th century. Some of thisdebate has been focused on U.S. business cycles, as discussed by Christina Romerin her contribution to this symposium. For international and historical evidence,the interested reader might begin with Backus and Kehoe (1992) and Bergman,Bordo and Jonung (1998). Interpretations of the historical international evidenceare complicated by the fact that they use annual data, rather than higher frequencydata, which makes it hard to measure the length of cycles accurately. Moreover, thesample size, as measured by the number of business cycles that has occurred,remains relatively small.

One simple way to look at economic volatility is to compare the standard deviationof key economic variables during various time periods. This information is presentedin the first five rows of Table 1.2 If one pools the data for the 15 countries during eachof the four time periods, one finds that the standard deviation of output, consumption,investment, and the current account (as a share of GDP) rises by about one-half fromthe time of the gold standard (1870–1914) to the interwar period (1919–1939). Then,in the Bretton Woods period (1945–1971), these standard deviations fall back to the

2 Following recent practice, we detrend all our series as necessary using a bandpass filter that is designedto isolate fluctuations at business cycle frequencies: those lasting between two to eight years. See Baxterand King (1995) for details and for a comparison with the usual Hodrick-Prescott filter. They argue thatthe bandpass filter has more desirable transfer properties for the isolation of specific business-cyclefrequencies in the data. It is the filter used by Stock and Watson (1998) and Bergman, Bordo, andJonung (1998). In contrast, the Hodrick-Prescott filter used in earlier studies passes much of theundesirable lower-frequency content in the series outside the business-cycle range. For this reason ourfindings do not necessarily match previous findings. An example would be the autocorrelation ofoutput: our study finds much lower values for this parameter than is the case with Hodrick-Prescott (orlinear, or quadratic) detrending. This is another way of saying that other methods make the growthcomponent “too smooth” and the cyclical component more volatile and autocorrelated.


level seen during the gold standard period, and in the more recent period of floatingexchange rates, the level of volatility falls lower still. Given the uncertainties of inter-preting annual historical data, it would be difficult to make a definitive case that today’sbusiness cycles are less volatile than those of a century ago in this cross section of 15countries, although Bergman, Bordo and Jonung (1998) make an effort along theselines. However, the notion of significantly higher volatility in the interwar period canbe easily supported.3

Although the volatility of consumption and the current account ratio aresimilar to that of output, the volatility of investment is about three to four timeshigher. It is striking that the ratio of investment volatility to consumption or outputvolatility seems to be fairly stable across all four time periods, even though eco-nomic structures within countries and international linkages across countries var-ied considerably. An adequate business cycle theory should seek to explain therelatively high volatility of investment as compared to other aggregate quantities.

3 Most of our findings hold at the individual country level as well as in the pooled data. In what follows,we try to indicate important cases when they do not. The longer working paper version of this analysis,available from the authors upon request, provides a fuller depiction of the country-level results.

Table 1Macroeconomic Aggregates

Statistic

Gold Standard Interwar Bretton Woods Float

Volatility log Y 0.027 0.036 0.025 0.016log C 0.034 0.042 0.032 0.016log I 0.113 0.186 0.103 0.068CA/Y 0.051 0.042 0.024 0.027log P 0.033 0.742 0.046 0.163

Persistence log Y 20.062 0.185 20.028 0.221log C 20.012 0.060 20.008 0.199log I 20.128 0.125 20.093 0.176CA/Y 0.835 0.565 0.395 0.774log P 0.164 0.175 0.405 0.489

Comovementwith Output log C 0.650 0.664 0.727 0.613

log I 0.461 0.487 0.368 0.778CA/Y 20.054 20.073 20.233 20.175log P 20.277 20.041 20.135 20.356

Comovementwith U.S. log C 0.084 20.008 0.035 0.150

log I 0.074 0.427 0.276 0.237CA/Y 0.033 20.266 20.104 20.058log P 0.128 0.038 0.241 0.055

Notes: Pooled data for 15 countries: Argentina, Australia, Canada, Denmark, Finland, France, Germany,Italy, Japan, Netherlands, Norway, Spain, Sweden, United Kingdom, United States. For series x, volatilityis standard deviation of x; persistence is autocorrelation of x with its first lag; comovement with outputis correlation of x with log Y; comovement with U.S. is correlation of x with the U.S. series x. All seriesare bandpass prefiltered. See text.

Business Cycles in International Historical Perspective 49

What might explain the common pattern of rising and then falling volatilityover the very long-run? At one level, this pattern simply documents the enormousdislocations associated with the Great Depression. This raises the question ofwhether the Depression should be treated as a singular, anomalous event, or alitmus test for any general theory of business cycles. A middle-of-the-road approachmight attempt to develop a universal business cycle theory that includes small andbig recessions, while recognizing that something different may have occurred in the1930s. For example, one possibility is that the interwar era was potentially a morevolatile era, at least in part, because World War I and various restrictions of the1920s and 1930s led to a sharp reduction in flows of international goods andcapital. In turn, this meant that the ability to spread risk in production andconsumption activities via capital markets could also have led to autarkic tendenciesin these economies, exacerbating any economic shocks that occurred (Obstfeldand Taylor, 1999). Under this view, the more recent integration of the world’seconomies would help to explain the lower amplitude of contemporary businesscycles (Bergman, Bordo and Jonung, 1998). However, this explanation is notwithout its problems, or offsetting considerations. For example, any shocks to aneconomy that affect investment productivity ought to have relatively small effects oninvestment in autarkic economies, where investment is constrained by the supply ofdomestic savings, but big effects in open economies, since foreign capital can movein or out freely. However, investment volatility was higher in the period of interwarautarky than in other eras. Thus, perhaps a more complex model is needed, orperhaps differing shocks need to be admitted in different periods.

The evidence on volatility of price levels, in the fifth row of Table 1, gives aslightly different perspective. There is clear evidence that the two periods of mostlyfixed exchange rates—the gold standard and Bretton Woods—delivered far lessprice volatility than the interwar period. However, price level volatility in recentyears seems to be slightly higher than in the periods of fixed exchange rates. Itshould be noted that the pooled results mislead a little here: they are heavilyinfluenced by two outlandish episodes of inflation, the German hyperinflation inthe 1920s and the Argentine hyperinflations of the 1980s. But more broadly, itseems true that when countries are committed to fixed nominal exchange rates,they are restrained from engaging in discretionary monetary policy, and price levelsmove by less. The price evidence offers some prima facie evidence that monetarypolicy and its interaction with exchange rate regimes is one potential source ofeconomic shocks. From this perspective, it seems somewhat remarkable that therecent period of floating exchange rates has not unleashed any truly substantialincrease in price volatility as compared to the Bretton Woods era (with theegregious exception, in our sample, of Argentina).

A second important property of macroeconomic time series, along with vola-tility, is persistence, which can be measured as the autocorrelation of each variablewith its value in the previous time period. Evidence on persistence is presented inthe second five rows of Table 1. The level of persistence has been fairly low over thelast 100 years for output, consumption, and investment, but higher in the interwarand float periods. The interpretation of these results is not straightforward, since


over such a long time span the structure of the economy has probably changed.Still, the association of higher persistence with floating-rate regimes again supportsa focus on money as an important part of the business cycle dynamic.

The persistence of current accounts shows a pattern consistent with thedescriptive data on the evolution of the global capital market. As we have men-tioned, capital flows were large in the first and last sample periods; we now also seethat they were much more persistent (Taylor, 1996). One rationalization for thispattern is that, under autarkic capital markets, not only do capital flows tend to zeroin size, they also become less sustainable over time. One way to think of this is interms of the adjustment speed towards equilibrium as defined by an economy’slong-run budget constraint. For that constraint to be met, the current account mustbe stationary (Wickens and Uctum, 1993; Trehan and Walsh, 1991). The ability tosustain persistent current account deficits may be seen as a facet of the autarkyversus openness continuum in capital markets. Markets with information imper-fections or transaction cost barriers may be less likely to support a prolongedone-way flow of capital (and, in the stock dimension, the corresponding buildup ofindebtedness) as compared to perfectly functioning open markets.

A third characteristic of business cycle data is the extent to which other seriesmove with output. The correlation of consumption with output, for example, seemsto be about 0.6–0.7 in all four time periods. This correlation is strikingly high, andsuggests that consumption-smoothing has been fairly uniform over time. Thispaints a very gloomy picture of the capacity of individual countries to insulatethemselves from output shocks through international risk-sharing.4 Investment hasalso been highly correlated with output, though less so during the Bretton Woodsera. Here again, an open-economy perspective might argue that the pervasivecapital controls of the Bretton Woods era dampened the impact of foreign capitalflows, thus lessening the investment response in booms and busts, and moving aneconomy closer toward autarkic capital market constraints. However, a parallelargument would then hold that the interwar period should have had less volatilityin investment as well, which clearly is not true. This suggests trying to identify somestructural differences in the interwar period that may have exacerbated investmentvolatility, perhaps leaning on financial aspects of the Great Slump or debt-deflationissues. The current account has generally moved in countercyclical fashion, aspredicted by most standard models with real shocks (Mendoza, 1991; Glick andRogoff, 1992; Backus, Kehoe, and Kydland, 1994). But note that this correlation wasstrong under Bretton Woods, when the option to use the current account as abuffer was seemingly weakest. In some dimensions, then, the quantity evidencedoes not always line up simply and predictably with the stylized facts on market

4 An attempt was also made to isolate local from global shocks by constructing a correlation of just thecountry-specific components of the quantity series; that is, each of the data was first detrended for theaverage world patterns, and then the correlations were re-estimated. These results do not greatly differfrom the raw results just reported, although the correlations of country-specific shocks to consumptionand output are smaller than in the raw data. This approach represents a standard test, in the case ofconsumption, for the extent of international risk-sharing (Lewis, 1996).


integration. Here again, some further analysis of the types of admissible shocksseems desirable.

Finally, we can look at the comovements across countries, arbitrarily selectingthe United States as a benchmark. We soon encounter some more anomalies of thekind seen in earlier studies (Backus, Kehoe and Kydland, 1993). There is very littlecross-country correlation in consumption. This demonstrates the extreme lack ofrisk-sharing in the global economy, for if all country-specific risks were insured anddiversified, then all consumption paths would move together in response to shocks.Another striking finding is that investment is very positively correlated acrosscountries. In a standard model, where mobile capital is flowing in response to ashock by leaving one country and heading overseas, one would expect a negativecorrelation (unless all shocks are global in nature). Perhaps this result is an artifactof using two-country models when the world has many more countries, so thatinvestment booms on one country do not automatically crowd out investmenteverywhere else: this is clearly a direction for future research. The price correla-tions across countries line up with the predictions of the changing monetaryregimes. In the fixed exchange rate regimes, the rapid transmission of prices fromcountry to country was assured by relatively open markets for goods and a fixedexchange rate. In the interwar period, this correlation broke down; prices had noneed to move so much when nominal exchange rates could do the adjusting.Bretton Woods was a return to the former dynamic, and the float a rerun of thelatter. It would be hard to imagine a business cycle model that could producepredictions of these patterns in a cross-section of countries without explicit atten-tion to the changing monetary regime and the integration of global markets.

Some Key Issues in Choosing Between Business Cycle Models

Certain key questions arise across a range of plausible business cycle models.Should monetary shocks be treated as neutral? Are nominal prices sticky? Do labormarkets clear? Can a plausible model of business cycles be set in a closed economy,or should presumption favor an open-economy model? Although the precedingdiscussion has already hinted strongly at our beliefs on some of these issues, it isuseful to discuss why these questions matter in various business cycle models andwhat our historical and international evidence has to say about them.

Is Money Neutral?In basic neoclassical models, money is neutral; that is, it does not affect real

variables like output or employment at any time horizon. One avenue for explain-ing business cycles is to argue either that shocks to the money supply may have realeffects on the economy, or that money may play a role in propagating non-monetary shocks through an economy. A huge literature has attempted to test forthe effects of money on output, while attempting to control for reverse causalityfrom output to money. The literature is usually partitioned into the “narrativeapproach,” which tries to identify exogenous changes in money from institutional


records (Friedman and Schwartz, 1963; Romer and Romer, 1989), and the statis-tical approach, which attempts to do the same thing using an econometric model(Christiano, Eichenbaum, and Evans, 1998, summarize recent work). Both ap-proaches have found strong evidence that money is not always neutral, especially inthe short-run.

However, the fundamental issue of causality continues to bedevil the literatureon links between money and output. Even if changes in money precede changes inoutput, one can argue that there is a post hoc, ergo propter hoc fallacy (Tobin, 1970).We believe that the behavior of real exchange rates provides compelling evidencethat money is not neutral, and evidence of a sort that is easier to defend against thepossibility of reverse causation.

If money is neutral, then the nominal exchange rate should move withinflation, while the real exchange rate adjusts to changes in economic fundamen-tals, like changes in national saving. In an excellent survey, Devereux (1997) arguesthat the available evidence supports the notion that real exchange rates adjust toreflect purchasing power parity (PPP), but the speed of adjustment toward the PPPexchange rate is extremely slow.5 In the short-run, nominal exchange rates remainmuch more volatile than macroeconomic fundamentals would predict (Meese andRogoff, 1983). In their useful summary of the evidence on the behavior of realexchange rates, Frankel and Rose (1995) point out that real and nominal exchangerates seem to move virtually one-for-one.

Table 2 presents some basic evidence on the relationship between monetaryregime and exchange rate volatility. The first row shows the volatility of nominalexchange rates based on pooled data from 20 countries, as measured by thestandard deviation of the log of the exchange rate. The second row shows volatilityof real exchange rates, calculated in the same way, where the real exchange rate iscalculated by converting all currencies into U.S. dollars. The third row presents analternative measure of real exchange rates, where the exchange rate for eachcountry is calculated relative to a basket of the 19 other currencies. Floating-rateeras such as the interwar and the post-1971 years clearly show higher volatility ofboth real and nominal rates as compared with fixed-rate eras such as the classicalgold standard and Bretton Woods. This association holds up just as well on acountry-by-country basis.

While we believe that the evidence from real and nominal exchange ratesdemonstrates convincingly that money is not neutral, several issues and puzzlesremain. First, in looking at exchange rate regimes to study the neutrality of money,it is important to remember that the regime itself may be endogenous. Countriesthat face larger real shocks may allow their exchange rates to float, while stablecountries may use a fixed exchange rate as a nominal anchor (Stockman, 1987).However, for certain major historical regime switches, such an explanation appears

5 For further discussions of the adjustment speed, see Froot and Rogoff (1995) and Taylor (1995). Somemore recent work using nonlinear methods suggests that reversion might be “only” one or two years(Obstfeld and Taylor, 1997; O’Connell and Wei, 1997), but even that speed of reversion would still seemto indicate substantial impediments to short-run nominal adjustment.


implausible. When Bretton Woods collapsed, for example, almost every countryabandoned fixed exchange rates at once. When the gold standard fell apart in theinterwar period, there was a systematic relationship between regime choice and realoutcomes inconsistent with the endogenous response story: those who abandonedgold did better (Eichengreen and Sachs, 1985; Obstfeld and Taylor, 1998)—apparently, they were not being buffeted by larger real shocks!

Second and more seriously, apart from a watershed historical event like theGreat Depression, there is little evidence that the behavior of real exchange ratesmatters for other macroeconomic aggregates (Baxter and Stockman, 1989; Frankeland Rose, 1995). This finding is a puzzle for models of all types, since everyeconomic model argues that prices should matter for the determination of quan-tities, even if models differ in their accounts of how these prices are set.

Finally, what models can we use to explain the long-lasting real effects ofmoney that are evident in the behavior of real exchange rates? A variety of modelswith satisfactory microfoundations have been proposed (see Devereux, 1997, for asurvey), but so far none can plausibly explain the persistence of the deviation ofnominal exchange rates from their purchasing power parity levels. We believe thatmodels with nominal rigidities of some sort hold the most promise, and discusssuch models in the next two subsections. Here, we simply conclude that a goodbusiness cycle model should be able to deliver both short-run monetary nonneu-trality and long-run reversion to neutrality. For exchange rates, such a modelshould produce what may seem like too much volatility in the short-run, combinedwith a long-run reversion to the purchasing power parity exchange rate. Further,the model should be able to explain why properties like the degree of volatility inexchange rates will vary under different monetary regimes.

Are Prices Sticky?A variety of economic institutions could allow monetary shocks to have real

effects. One family of models is designed to obtain real effects of monetary shocks

Table 2Real and Nominal Exchange-Rate Volatility

Statistic


Volatility E 0.051 0.162 0.145 0.424RER-US 0.056 0.173 0.094 0.129RER-W 0.054 0.088 0.062 0.110

Notes: Pooled data for 20 countries: Argentina, Australia, Belgium, Brazil, Canada, Denmark, Finland,France, Germany, Italy, Japan, Mexico, Netherlands, Norway, Portugal, Spain, Sweden, Switzerland,United Kingdom, United States. E is the nominal exchange rate, RER-US the real exchange rate relativeto the U.S. dollar, and RER-W is the real exchange rate relative to a basket of the 19 other currencies.Volatility is standard deviation of log x, for x 5 E, RER-US, and RER-W. All series are differenceprefiltered. See text.


even with perfectly flexible wages and prices. Perhaps the best-known of thesemodels remains Lucas’s striking (1972) paper, which shows that monetary shockscan have real effects if people have incomplete information and cannot distinguishbetween changes in relative prices and changes in the overall price level. However,by the mid-1980s enough evidence had accumulated against this particular modelthat it fell out of favor (Blanchard, 1990). A more recent model in a similar spiritstresses the lack of continuous adjustment of real money balances (Lucas, 1990;Fuerst, 1992). In these “liquidity” models, a change in the stock of high-poweredmoney typically changes the real interest rate, which affects the cost of workingcapital, and thus the aggregate demand for labor and aggregate output, eventhough prices are flexible.

However, the earliest models of the real effects of money, dating back at least toHume’s 1752 essay, have stressed slow adjustment of wages and/or prices. The “NewKeynesian” literature has emphasized flexible wages and sticky output prices. Givensome assumed nominal friction—for example, a small fixed cost of changing prices,often termed a “menu cost”—this literature attempts to derive Keynesian results fromrigorous foundations. For analytical tractability, dynamic New Keynesian models typi-cally assume that prices are set for a fixed length of time: a so-called time-dependentrule. The alternative is to assume a state-dependent rule—firms face some cost of priceadjustment, and thus do not change their prices continuously or at fixed intervals oftime, but rather when the benefit of changing the price exceeds the cost. Dynamicstate-dependent models are extremely difficult to analyze (Caplin and Leahy, 1997).6

However, Ball, Mankiw and Romer (1988) had the insight that one can combine someof the appealing features of both time- and state-dependent models in a tractableframework. In their model, firms in each country follow a time-dependent pricing rule,but choose the length of time between price changes to be optimal on average. Theyshowed that in such a framework, firms in high-inflation countries should changeprices more frequently, because the loss of keeping one’s nominal price fixed is higherwhen inflation is high.

Kiley (1999) extends this insight to consider the persistence of output fluctu-ations. He notes that in sticky-price models, output deviates from its long-rungrowth rate only as long as there is significant nominal price inertia. But, followingthe logic of Ball, Mankiw and Romer (1988), nominal prices change more quicklyin countries with high average inflation rates. Thus, countries with high meaninflation should have less persistent deviations of output from trend—a linking ofreal and nominal variables that is difficult to rationalize unless sticky prices are amajor force propagating business cycles.7 Kiley tests this insight in a regressionframework. The dependent variable is a measure of output persistence, the first

6 The first “New Keynesian” models of price stickiness, by Akerlof and Yellen (1985) and Mankiw (1985),are static and state-dependent.7 As Ball, Mankiw and Romer note, such a link certainly does not arise in the Lucas (1972) model. Asfor the liquidity models, they typically have little to say about the persistence of output fluctuations.Christiano, Eichenbaum, and Evans (1997) argue that a liquidity model can explain the behavior ofcorporate profits over the cycle better than a sticky-price model. However, the profit data that oneobserves are accounting profits, not economic profits; Rotemberg and Woodford (1998) explain at


autocorrelation of detrended (log) output growth for each country. The explana-tory variable is the level of mean (log) inflation. Using a sample of 43 countries overthe 1948–96 period, Kiley finds a statistically significant, negative connectionbetween these variables, as the theory predicts.8

Kiley’s findings offer a simple and robust implication of fixed-price models,and it is difficult to see how other classes of models would explain them. Since hismodel relates output persistence to the frequency of price change, one can inter-pret his results using that frequency as a metric. Kiley’s results imply that in theUnited States, which had 4 percent mean annual inflation over the postwar periodand highly serially correlated output, the average price was changed once aboutevery 2.5 years. On the other hand, in Argentina, which had mean inflation of 58percent and little output persistence, prices changed more than once a year—aneconomically significant difference. However, this implication of Keynesian theoryis hard to reconcile with one of the facts we have noted above. According to theBall-Mankiw-Romer/Kiley hypothesis, business cycle fluctuations should have beenmuch more volatile and persistent in the gold standard period, which had very lowmean inflation, than in the floating period since 1971 or so, which has had muchhigher inflation. But as Table 1 shows, this prediction was not borne out. Thus, ifone embraces the New Keynesian model, one has to find some offsetting factor inorder to explain the low persistence of fluctuations in the early periods.

The Great Depression provides further evidence in support of theories withnominal rigidities. Countries that abandoned the gold standard, particularly thosethat devalued aggressively and used their newfound monetary policy freedom,experienced faster recoveries. Short-run competitive (real) depreciations drovecurrent account balances to a surplus and stimulated the economy; though pricesdid rise, they adjusted less rapidly than the exchange rate. The experience of theGreat Depression provides strong evidence, albeit based on one historical episode,that money is not neutral and that monetary policy can drive large output fluctu-ations. Given the magnitude of the Depression across so many countries, it seemsimplausible to attribute this particular downturn to unobserved real shocks. In-stead, most authors have sought a monetary explanation of some sort or other.Friedman and Schwartz’s (1963) magisterial account of the Depression attributesits severity to U.S. monetary policy mistakes. Recent accounts by economic histo-rians such as Temin (1989) and Eichengreen (1992) also emphasize a monetary

length why non-liquidity models can account equally well for the procyclical behavior of accountingprofits.8 We duplicated Kiley’s exercise for our cross-section sample of 15 countries, but the results were notstatistically significant in any of four major time periods, and were of the “wrong” sign in several of theperiods. Our different findings seem to be caused by our different sample period and countries. Sinceour sample consists predominantly of countries with stable macroeconomic histories, we are probablylacking some useful variation that would help pin down the relationship between inflation and outputpersistence. For example, we are missing Brazil, Israel, and Peru, which are all high-inflation, low-persistence countries in Kiley’s sample. When we used Kiley’s (1999) sample period (and detrendingmethod) with our 15 countries, we still get essentially no significant relationship between the twovariables.


origin for the global depression by drawing attention to instabilities and asymme-tries in the functioning of the interwar gold standard.

Thus, the data imply that nominal rigidities are important, and can lead evento such massive economic downturns as the Great Depression. But we face the samequestion in explaining large and long-lasting contractions in output as we do inexplaining the exchange rate evidence: Can we reproduce these facts in a modelbuilt from rigorous microfoundations? The New Keynesian research program hasproduced models where price stickiness comes from the optimizing behavior offirms. But these models also imply that prices will not be sticky for long periods oftime, or in the face of large shocks, unless the private cost of price rigidity is small.In an insightful paper, Ball and Romer (1990) argue that there are two broadcategories of reasons why the private cost of price rigidity might be small, even ifprice rigidity is socially very inefficient. First, the private cost is small if firms’marginal cost of production are not strongly cyclical. Second, even if marginal costis procyclical, the private cost of keeping prices fixed is small if firms actually desirelower price-cost markups in booms. These features come from the real side of amodel, and have no necessary connection with nominal rigidities per se. In Ball andRomer’s terminology, one thus needs a model with a great deal of “real rigidity” toexplain the observed nominal price rigidity.9

In practice, the most important real rigidities are probably those associatedwith the labor market. We noted that the evidence from exchange rates and outputfluctuations supports the proposition that money is not neutral, but that evidenceby itself fails to tell us whether the nominal rigidity is in prices or wages. Theevidence from Ball, Mankiw and Romer (1988) and Kiley (1999) might applyequally well to pre-set nominal wages as to pre-set prices. The evidence that hasbeen used to discriminate between these two Keynesian models is the cyclicalbehavior of the real wage. We discuss some of this evidence in the next section.

Does the Labor Market Clear?Modeling the labor market is a challenge and a puzzle for all classes of business

cycle theories. A model of business cycles should be able to explain one of the mostrobust facts of economic fluctuations: that consumption and labor input both trackthe business cycle—labor hours almost one-for-one with output, consumption lessthan one-for-one. Reproducing this comovement, however, has proved a challengefor business cycle theory.

It is now usual in business cycle models to represent the household side ofthese models with a representative consumer who takes prices as given, and freelychooses consumption and labor supply. Then utility-maximizing households must,at all points in time, equate the marginal utility of leisure to the real wage

9 Ball and Romer (1990) derived their propositions in the static setting of the early menu cost models.Kimball (1995) confirms that their results hold in a dynamic setting, in a model that is also consistentwith the facts about long-run growth. However, Kimball (1995) and Chari, Kehoe and McGrattan (1996)disagree on the extent to which reasonable real rigidities can explain large and persistent outputfluctuations.


multiplied by the marginal utility of consumption. Barro and King (1984) point outthat under reasonable conditions, this relationship implies that if consumption andlabor supply are rising and falling together over the business cycle, then real wagesmust be procyclical as well.10 In this framework, which is common to most modernbusiness-cycle models, only a procyclical real wage can rationalize the positivecomovement of consumption and labor over the business cycle. This conclusionholds regardless of the other details of the model—whether the cycle is driven bysupply or demand shocks, whether firms are imperfect competitors, or whethernominal prices are sticky.

Thus, business-cycle theorists face two choices: They can build models in whichthe real wage is procyclical, or they can deny the proposition that workers freelychoose labor and consumption at given wages and prices. We discuss these twoalternatives in turn.

To consider models in which the real wage is procyclical, suppose a represen-tative firm is assumed to be a price taker in factor markets; thus, the firm equatesits nominal marginal revenue product of labor to the going nominal wage. How-ever, the firm may be operating in an imperfectly competitive market for its output,and thus have some market power to mark up price over marginal cost. In thisframework, there are three main ways in which a procyclical real wage can beconsistent with cost minimization by firms.

First, the markup may fall during booms. In sticky price models, for example,the markup falls during booms as firms leave their prices fixed but face increasingmarginal costs of production in a boom—especially a higher real wage. Othermodels assume that prices are flexible but show that firms may lower their optimalmarkups in booms, either because they want to “lock in” new customers (Bils, 1989;Warner and Barsky, 1995), or because they cannot sustain a high degree ofcollusion in times of high demand (Rotemberg and Woodford, 1995). This ap-proach has been the focus of most New Keynesian theories of the business cycle.

Second, technology may improve during booms. This is the domain of thestandard real business cycle model where cycles are driven by exogenous changesin technology, and where improved technology drives both higher wages andhigher output. A variant of this approach in Shleifer (1986) presents a model wheretechnical improvements are demand-induced. A recent literature stresses, however,that the short-run effects of technology improvements can be quite different in aworld where prices are sticky. Gali (1998) and Basu, Fernald and Kimball (1998)argue that if prices are sticky, a technology improvement lowers employment in theshort-run, and may lower output as well. Thus, the assumption of flexible prices inthe real business cycle model is not merely an assumption of convenience; it isessential for generating the desired outcomes of the story.

10 This implication is not a general consequence of consumer optimization, but it holds if there is arepresentative consumer whose utility at each date is a function only of consumption and leisure at thatdate. This framework does allow for “preference shocks” which can change the marginal rate ofsubstitution between consumption and leisure, even at a fixed real wage. However, it is unappealing toembrace a model that implies some recessions are times of spontaneous laziness.


Third, if there are increasing returns to scale of a particularly strong form, themarginal product of labor might rise as more labor is employed during booms. Anumber of papers have shown that if this effect is sufficiently strong multipleequilibria may exist, with higher output equilibria being superior in welfare terms;for early work in this area, see the symposium in the 1994 Journal of Economic Theory.However, there is no evidence that returns to scale are large enough to producethese multiple equilibria (Basu and Fernald, 1997; Schmitt-Grohe, 1997). Analternative approach has been to substitute sufficiently countercyclical markups foreconomies of scale (Gali, 1994), but this approach also requires a markup that istoo high to be plausible (Schmitt-Grohe, 1997). A more recent approach hasattempted to produce multiple equilibria with smaller returns to scale by usingmulti-sector models (Benhabib and Farmer, 1996; Benhabib and Nishimura, 1998).The major difficulty of most multi-sector models is that they tend to have one ormore sectors that contract while the overall economy is expanding—a phenome-non that is not observed in the data (Murphy, Shleifer and Vishny, 1989).

“Equilibrium” models with labor markets that clear are obviously attractive toeconomists, but they now appear implausible. Remember, labor fluctuates almostas much as output over the business cycle. However, the elasticity of labor supplywith respect to wages appears to be relatively small. If workers willingly supply somuch more labor, then the required change in the real wage to call forth this laborsupply is immense. In general, therefore, a clearing labor market is an embarrass-ment for all business cycle theories that assume workers are on their labor supplycurves. In the context of the real business cycle and other real models, it means thatthe shocks hitting the economy must be extremely large—and such shocks are hardto identify. In the context of sticky-price models, it means that firms’ marginal costsare extremely procyclical—so much so that they would not hold prices fixed.11

One alternative is to posit so-called “Old Keynesian” models in which workersare not on their labor supply curves. Keynes (1936, ch. 20) clearly believed thatquantity rationing in the labor market was an essential feature of his theory ofunemployment. Most early Keynesian models thus assumed that nominal wages aresticky, and also that employment is determined by labor demand. These assump-tions allowed for the possibility of involuntary unemployment in recessions, if thereal wage exceeded its market-clearing level. In contrast to the “equilibrium”models we have discussed, these models generally predict that real wages should becountercyclical.12 Almost from its inception, however, the literature on nominalwage stickiness was criticized precisely because it implied a countercyclical realwage. Dunlop (1938), for example, argued that the evidence contradicts thisimplication of Keynes’s General Theory.13

11 Romer (1993) has an insightful discussion of labor market rigidity and its relationship to NewKeynesian theory.12 It is logically possible to have a model with sticky nominal wages but with markups so countercyclicalthat real wages rise in expansions. However, this model makes the unappealing prediction that increasesin aggregate demand reduce the price level.13 In this journal, Dunlop (1998) discusses his exchange with Keynes.


Another possibility is to marry some of the equilibrium models discussed abovewith labor market imperfections that keep workers off their labor supply curves.These models typically also imply that real wages are procyclical, but not asprocyclical as they would be if the labor market cleared. The desire to have a modelthat predicts roughly acyclical real wages has led a number of New Keynesianmacroeconomists to embrace labor market imperfections. For example, Akerlofand Yellen (1985) assume that there are efficiency wages in the labor market, whereworkers are paid above their marginal product to encourage effort and discourageturnover, along with sticky prices in the product market. The problem with thisapproach is that it does not suffice to explain all the facts. If efficiency-wage theoryis correct and effective labor supply is very elastic, then we should observe a highparticipation elasticity (large movements in and out of the labor force in responseto real wage changes), even if the labor supply elasticity of employed workers is low.It is true that the participation elasticity is usually estimated to be larger than thehours elasticity of employed workers, but not by so much as to make a majordifference for business cycle modeling.14 Thus, the real challenge is to explain howthe real wage that firms pay can be relatively acyclical even when both estimatedelasticities are relatively small.

Finally, one can marry the New and Old Keynesian approaches, and argue thatreal wages may be not be strongly procyclical because both wages and prices havenominal inertia (Barro and Grossman, 1971; Erceg, 1997). However, this approachhas some of the same costs as Old Keynesian theory, one of which is that one mustabandon equilibrium modeling of household decisions—in this model, householdsare quantity-constrained in the labor market.

If workers are not on their labor supply curves, either because of real imper-fections in the labor market or due to nominal wage rigidity, business cyclemodeling becomes dramatically easier. If real wages, and hence firms’ marginalcosts, are not strongly procyclical, then nominal inertia will last much longer, andnominal shocks will have the large real effects in the models that they seem to havein the data.

Thus, business cycles models with clearing labor markets predict stronglyprocyclical real wages, while models with imperfect labor markets predict acyclicalor countercyclical real wages. We can examine the empirical evidence on real wagesover the business cycle with historical and international data. Table 3 presentsevidence on the real wage, pooling data across 13 countries. In keeping with theformat of Table 1, earlier, the first two rows present information on the volatilityand persistence of real wages. The last row presents evidence on the comovementof wages and output.15

The real wage is basically acyclical during the first two periods of our study andreasonably procyclical in the third and fourth. At face value, these results are

14 The same objection applies to the “indivisible labor” model of Hansen (1985) and Rogerson (1988).That model, which is widely used in the real business cycle literature, implies that the observedparticipation elasticity should be infinite.15 Once again, we employ bandpass prefilters; see note 2 for a discussion.


something of a puzzle. In the first two periods, the wage is not so procyclical as tosupport the hypothesis that the labor market clears, but neither is it stronglycountercyclical, as “old” Keynesian theory predicts it should be. These results admitof several lines of interpretation: we can question the validity of the data itself, orwe can seek explanations for the observed patterns.

One data issue that makes us hesitate to endorse the conclusion that real wageswere actually acyclical for most of our sample concerns a built-in composition biasin the wage data. Stockman (1983) suggests that workers hired during a boom maybe of lower average quality. Solon, Barsky and Parker (1994) show that Stockman’sconjecture is correct: real wages controlling for worker characteristics are muchmore procyclical than average wage indices of the sort that we are forced to use.However, the composition bias applies to data from all periods, so it does notobviously explain the subsample differences we observe.

A second issue concerning the wage data is that the real wage we observe neednot be the effective real wage. For example, Bils (1987) argues that in the UnitedStates the marginal wage is more procyclical than the average wage because of thestatutory overtime premium mandated by the Fair Labor Standards Act of 1938.The overtime premium may be relevant only for particular countries and recenthistorical periods, but other reasons along these lines may be more general. Thepossibility of a gap between actual and effective wages raises difficult issues forstudying the behavior of wages over the business cycle.

But let us assume that the wage patterns we have found—namely, acyclicalityover the first two time periods and procyclicality in the two most recent peri-ods—do in fact hold, despite concerns over the data. How might a business-cyclemodel explain such a pattern?

First, perhaps demand shocks lead to countercyclical changes in real wages, inthe spirit of traditional Keynesian models, while supply shocks lead to procyclicalchanges, in the spirit of real business cycle models. Thus, it could be that in earliertime periods, supply and demand shocks roughly offset each other. However, themore recent period of floating exchange rates includes several large oil priceshocks, both negative shocks in the 1970s and a positive shock in the 1980s. Perhaps

Table 3Real Wage Cyclicality

Statistic


Volatility 0.038 0.042 0.042 0.033Persistence 0.138 0.098 0.151 0.166Comovement with Output 0.025 20.059 0.162 0.271

Notes: Pooled data for 13 countries: Argentina, Australia, Canada, Denmark, France, Germany, Italy,Netherlands, Norway, Spain, Sweden, United Kingdom, United States. Given the real wage w, volatilityis standard deviation of log w; persistence is autocorrelation of log w with its first lag; comovement withoutput is correlation of log w with log Y. All series are bandpass prefiltered. See text.


the strong procyclicality of the real wage in the most recent period is due to thegreater importance of supply shocks. This possible answer arrives with its ownquestions. Under standard conditions—perfect competition and the existence of avalue-added production function for GDP—the ratio of the nominal wage to theGDP deflator should be unaffected by changes in oil price (Rotemberg andWoodford, 1996). But we are deflating the nominal wage by the Consumer PriceIndex, and Barsky and Kilian (1998) establish that the CPI changes far more thanthe GDP deflator during oil shocks. Thus, increases in oil prices will tend to lowerour measure of the real wage at the same time that they lower output (eitherdirectly, or because central banks try to fight the inflationary effects of oil priceincreases).

To find support for a pattern of countercyclical wages at times of demandshocks, an obvious place to look is at a business cycle that is broadly agreed to haveresulted from demand shocks—the Great Depression. In their path-breaking paperon the Depression, Eichengreen and Sachs (1985) argued in favor of the traditionalsticky-wage story. Their empirical work has been extended in a careful paper byBernanke and Carey (1996) who find that real wages were strongly countercyclicalin a 22-country sample over the years 1931–36. We sought to replicate these resultsin a 13-country sample. Our data show some heterogeneity in the cyclicality of realwages across countries, and sensitivity to the sample period. For the Bernanke andCarey sample period from 1931–36, mostly the recovery phase of the Great Depres-sion, we find that although eight of our 13 countries experienced countercyclicalreal wages over this period, some of the others had strongly procyclical real wages,including the United States and United Kingdom. However, for the Eichengreen-Sachs sample period from 1929–35, which includes the downturn phase of theDepression, nine out of 13 had countercyclical real wages and only one (Spain) hadmarkedly procyclical real wages. Clearly, this sample problem is a matter of con-cern, as is the precise approach to defining real wages given the data.16 More workis needed to formulate robust findings about the degree of stickiness in wages andprices during the Depression, and there is some suggestion that stickiness mighthave been more of an issue during the onset of the Depression than during therecovery (Bordo, Erceg and Evans, 1997).

A second possible interpretation is that the real wage may have been approx-imately acyclical in the early periods, even in response to demand shocks, if pricesand wages were about equally sticky. Real wages may then be procyclical in the lastperiod because prices have become less procyclical, or nominal wages more so.Hanes (1999) finds evidence that prices were more procyclical before World War

16 Twelve of our 13 countries are in the Bernanke and Carey (1996) sample; Spain is the exception. Wedo prefer our real wage data because our nominal wages are deflated by the Consumer Price Index, thetheoretically correct price index for studying the tradeoff between consumption and leisure. By contrast,Bernanke and Carey use the Wholesale Price Index which, because of the large weight it gives tocommodity prices, is extremely cyclically sensitive. Thus, we suspect that their use of the WPI is at leastpartially responsible for their finding of an extremely countercyclical real wage. This is not the only dataproblem: there still remains the problem of composition bias alluded to in our earlier discussion of wagecyclicality; however, its importance in the Great Depression period is now in doubt (Dighe, 1997).


II than in the postwar period—a change that he attributes to an increase in thenumber of stages of processing of the typical product. More roundabout produc-tion can increase price stickiness—a conjecture dating at least to Means (1935), andinvestigated formally by Blanchard (1987) and Basu (1995).

Although many business cycle models seek to deliver a procyclical relationshipbetween real wages and output, we believe that such a pattern occurs only at certaintimes and places. Real wages have been more procyclical in the recent past than atany previous time, which may explain the recent popularity of models that predictstrongly procyclical real wages. But based on our examination of the historical data,we urge business cycle theorists to consider models that can produce wage patternsthat are procyclical, countercyclical, and sometimes just acyclical. Part of the payoffto such an effort, we suspect, will be a model in which it is easier to explain the largefluctuations in labor supply that we observe over the business cycle.

Business Cycles and the Open EconomySome business cycle models assume a purely closed economy, but such models

are obviously questionable when applied to the open global economy of the late19th century, and perhaps to the increasingly globalized world of the last fewdecades. Other studies explicitly admit models of capital mobility, with adjustmentsin consumption and investment relative to output mediated via the current ac-count. Yet these models may not be appropriate in a world of limited capitalmobility, as was the case for several decades in the middle of the 20th century.

One potentially useful approach here would be to specify the underlyingconditions that lead the economy to be open or closed, and then to bring thoseconditions into one’s model of the business cycle. Obstfeld and Taylor (1998) offera political economy interpretation based on what they call the macroeconomic policytrilemma. In this view, policymakers have wrestled with three basic macroeconomicchallenges for over 100 years: a desire to have fixed exchange rates to avoidinstability; a desire to have free capital mobility, to ensure efficient allocation andpermit smoothing; and a desire to engage in activist monetary policy to addressdomestic policy goals. The trilemma points out that three goals are mutuallyinconsistent: only two out of three are attainable. The gold standard solved thetrilemma by choosing fixed exchange rates and capital mobility, but left no roomfor activist policies—that is, interest rates were set in the world market. The 1920sand the Depression saw the rise of capital controls in some countries, and floatingexchange rates in others, as a means to admit activist monetary policy. These eventshave been seen as a response to a changing distribution of political power awayfrom orthodox financial interests, and toward non-elites, the working classes,organized labor, and the like (Polanyi, 1944; Eichengreen, 1996; Obstfeld andTaylor, 1998). Bretton Woods made a compromise; to let fixed rates back in, whilestill allowing discretionary monetary policy, capital mobility had to be sacrificed.The more recent period of floating exchange rates gave up on fixed rates, butallowed capital mobility and activist monetary policy. Save for a few unusualexperiments, like the move to European monetary union (a common currencyoffering something of an escape from the country-level trilemma), this is where we


stand today, and Eichengreen’s (1996, p. 192) conclusion appears to hold: floatingrates are here to stay.

Any business cycle theory with long-run applicability needs to keep in mind thetradeoff between macroeconomic activism, capital controls, and fixed exchangerates. Any naıve attempt to approach the macrohistorical data without some knowl-edge of these institutional events, and the broad contours of change in the globalcapital market, could lead to major misinterpretations. Our empirical work under-scores the importance of changing external constraints. For example, it seems likelythat an open capital market should lead to more volatile investment, thanks to aninflow and outflow of capital, and less volatile consumption, because of greaterpossibilities for smoothing consumption (Razin and Rose, 1994). By definition itwill lead to a more volatile current account (that is, one not fixed at zero).However, different models can sometimes produce unexpected results, dependingon the separability of saving and investment decisions, differences in the variabilityand persistence of shocks, and by differences across countries in technology andpreferences (Mendoza, 1994). In another example, we know that in a world ofperfect risk-sharing across nations, all agents would hold an internationally diver-sified wealth portfolio, and all wealth shocks would then be identical across coun-tries! In practice, however, most countries seem far from that diversified out-come—an observation termed the “home bias” or “international diversification”puzzle. However, depending again on the degree of integration in capital markets,we may expect to see more or less of this kind of diversification going on, andaccordingly more or less cross-country similarities in consumption patterns (Obst-feld, 1994; Lewis, 1996). These and other features of the data are issues that thenext generation of open-economy business cycle models must confront.

Conclusion

The evidence strongly suggests that money is not neutral. It is certainly difficultto explain the Great Depression without citing the effects of the gold standard, andit is difficult to reconcile the large changes in the time-series properties of realvariables across different exchange rate regimes without admitting some role formoney. Still, the channel by which money has its effects on the economy remainsvery much an open question. We have noted some evidence that favors models withnominal rigidities, but we need more evidence on this point. Even within the classof Keynesian models, it is not clear whether the sticky-price or the sticky-wagemodel is more plausible. More attention to these questions seems desirable, thoughsensitivity to country- and time-specific features—history and institutions—is likelyto color this line of inquiry.

However, even if one accepts our views regarding the class of plausible models,there is still a large gap between the models and the data. Most reasonablyparameterized models imply that marginal cost is very procyclical, but in fact, pricesseem to move by relatively little. Thus, much of modern business cycle theoryamounts to a search for empirically supported mechanisms to explain why marginal


cost should not rise much when output expands (for example, nominal or realwage rigidity), or reasons why firms should accept lower profit margins in booms.While economists debate the ultimate form of “the” right business cycle model,there is scope for much useful research on general sources of propagation whichwill be useful for explaining business cycles in almost any model. We see this lineof research as both necessary and fruitful, and urge a renewed focus on studying thelabor market.

Our work has also raised questions about research on business cycles that failsto take international linkages into account. Closed-economy macroeconomics mayhave been well suited to a few decades in the middle of the 20th century, but itsrelevance in other historical episodes—and in the globalized worlds of the presentand future—seems inherently limited. Surely, both theory and empirical will movemore in the direction of open economy models, with closed economy modelsderived as a special case.

Finally, our work highlights the political economy choices available and theconstraints facing policymakers—such as the classic trilemma—and how these caninform the model, its structure, its shocks, its calibration, its predictions, and itsscope for policy activism at different times in different regimes. We cannot claim tounderstand the determinants of business cycles without being able to explain whysome of their characteristics have changed significantly over the past century andwhy some have not. Only with attention to the historical and institutional contextcan we achieve a more complete understanding of economic fluctuations.

y We thank Robert Barsky, Michael Bordo, J. Bradford De Long, John Fernald, ChristopherHanes, Lars Jonung, Michael Kiley, Robert Margo, Ellen McGrattan, Maurice Obstfeld,Timothy Taylor, and Mark Watson for their help and suggestions. The usual disclaimerapplies.

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