Business cycle persistence in contemporary macroeconomics: a literature review

Abstract

The recession that followed the financial crisis in 2007 has pushed many economies away from their pre-crisis growth trajectories. This questions the idea that short-term fluctuations in output, often called business cycles, and long-term economic growth are independent from each other. Empirical findings support the idea that these two phenomena are indeed not independent, indicating that business cycles tend to have persistent effects on long-term economic growth. However, in economic theory, there is no direct relationship between business cycles and long-term growth or it is vaguely defined. In many macroeconomics textbooks, short run and long run are studied separately with different models.

In more advanced models, such as the New Keynesian DSGE model used by most researchers on the topic, this link is also not explicit. However, there is literature that attempts to establish such a link or to explain the persistent effects of business cycles in general. In this master’s thesis, I review this literature in order to construct an overview on how business cycle persistence is understood and modeled in contemporary economic theory. There are several explanations for business cycle persistence in macroeconomic theory and models. First, the existence of the zero lower bound on monetary policy and liquidity traps can have persistent effects on economic growth because the zero lower bound makes it possible to have two steady-state general equilibria in an economy simultaneously. One of these equilibria is often associated with a liquidity trap. Second, using the model of endogenous technological progress in macroeconomic models makes it possible to replicate the procyclical behavior in productivity growth often seen in real economies. This framework gives an explanation how short-term demand-side shocks can transform into medium-term supply-side shocks, which can decrease long-term growth potential. Third, according to the secular stagnation hypothesis, decreased long-term growth potential can also explain the recent persistence and lost output potential without linking short-term fluctuations and long-term growth. And finally, new methodologies in macroeconomic modeling, such as behavioristic decision-making rules, make models more consistent with the real economy and gives new insights for analyzing business cycle persistence. The apparent threat of business cycle persistence has also provoked some policy recommendations of rethinking monetary and fiscal policy, and regarding subsidizing R&D.