International Evidence on Friedman's Theory of the Business Cycle

By Goodwin, Thomas H.; Sweeney, Richard J. | Economic Inquiry, April 1993 | Go to article overview

International Evidence on Friedman's Theory of the Business Cycle


Goodwin, Thomas H., Sweeney, Richard J., Economic Inquiry


I. INTRODUCTION

Milton Friedman |1969; 1993~ discusses two empirical business cycle regularities he finds in U.S. data and conjectures that they may exist in other countries' data. First, Friedman argues that U.S. data on real output show an important "ceiling" effect; growth rates are on average below the ceiling rate, but tend back to the ceiling rate. Second, he finds an asymmetry in business cycles: The size of a contraction importantly influences the size of the following expansion, with major expansions tending to follow major contractions; the size of an expansion, however, has no stable relationship to the size of the following contraction. Friedman offers theoretical reasons for the existence of these regularities: The ceiling effect arises from aggregate supply constraints on the level of real output. As for asymmetry, aggregate demand disturbances (primarily from monetary shocks in Friedman's view) can reduce output below the ceiling, but the economy's equilibrating forces (and possibly expansionary monetary policy in reaction to the recession) push the economy back to the ceiling with the size of an expansion thus related to the size of the preceding contraction. The next contractionary aggregate demand disturbance is unrelated, in Friedman's view, to the size of the previous expansion, meaning that the size of a contraction is unrelated to the size of the preceding expansion. Both the regularities and his theoretical discussion have important implications for business cycle analysis; the empirical asymmetry Friedman suggests joins other asymmetries discussed in recent literature, for example, Hamilton |1989~, Neftci |1984~, Sichel |1993~. This paper follows Friedman's |1993~ suggestion to examine whether foreign data show the regularities he finds in U.S. data.

Friedman's model includes regime shifts: at times, the economy is on the potential output ceiling, where aggregate supply determines the evolution of the economy; at other times, aggregate demand disturbances force the economy below the ceiling, with movements below the ceiling determined by aggregate demand. Such regime shifting models are inherently nonlinear in important ways and pose serious challenges both for theoretical and empirical models. For example, in calibrating real business cycle models, it would be important to be able to generate Friedman's ceiling and asymmetry effects if in fact the data support these. Real business cycle models with continuous market clearing would then have to have a mechanism that does not rely, as does Friedman's, on sluggish price adjustment and deviations of output from its equilibrium level. Further, those Keynesian macroeconometric models where output is essentially demand-determined must somehow generate Friedman's ceiling and asymmetry effects.

If the ceiling and asymmetry effects that Friedman finds in U.S. data hold up across countries, their importance lies in the restrictions they impose on what is likely to be observed in the future and what patterns business models must be able to generate. The effects hold little promise of allowing discrimination among classes of models. Friedman's "plucking" model is a ceiling model like John Hicks's |1950~ model of the trade cycle. It is possible to construct Keynesian-type ceiling models where disturbances to consumption and investment demand cause contractions, with the size of the following expansion depending on the size of the contraction, and the size of these demand disturbances uncorrelated across cycles. It is also possible to construct monetarist models where the monetary authority's expansionary errors are correlated with its following contractionary errors, with the size of an expansion then having predictive power about the size of the next contraction. Thus, ceiling and asymmetry regularities do not allow discrimination between Keynesian and monetarist ceiling models. Friedman's |1993~ views contrast strongly with the real business cycle models of the past decade as in Long and Plosser |1983~ and King, Plosser and Rebelo |1988~ among many; the regularities Friedman finds conflict with simple real business cycle models, but we conjecture that if the regularities hold across countries, real business cycle models could be constructed that produced data on real output with these regularities. …

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