Accounting for the Great Recession in the UK: Real Business Cycles and Financial Frictions

By Jagjit S. Chadha and James Warren

http://d.repec.org/n?u=RePEc:ukc:ukcedp:1207&r=dge

Using the business cycle accounting (BCA) framework pioneered by Chari, Kehoe and McGratten (2006) we examine the 2008-09 recession in the UK. There has been much commentary on the financial causes of this recession, which we might have expected to shock the equation governing the intertemporal rate of substitution in consumption. However, the recession appears to have been mostly driven by shocks to the efficiency wedge in total production, rather than the intertemporal consumption, labour or spending wedge. From an expenditure perspective this result is consistent with the observed large falls in both consumption and investment during the recession. To assess this result we also simulate artificial data from a DSGE model in which asset price shocks dominate and find no strong role for the intertemporal consumption wedge using the BCA method. This result does not imply that financial frictions did not matter for the recent recession but that such frictions do not necessarily impact only on the intertemporal rate of substitution in consumption.

These are intriguing results and I wonder whether they stem from a missing wedge (a misspecification in econometric terms). Were the model to capture also, say, financial frictions, those would have likely become the main source or the recession. Absent this, the existing wedges need to absorb somehow the downturn, and the efficiency wedge (TFP) is the most likely candidate as the economy was suddenly producing less with the same real resources. Now repeating the exercise with a model that does feature some financial frictions (Bernanke-Gertler (1999)), the latter still do not capture the recession, but rather the labor wedge. Either financial frictions really did not matter for the UK, or the BGG model is not the right one.

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One Response to Accounting for the Great Recession in the UK: Real Business Cycles and Financial Frictions

  1. M. H. says:

    One could also ask oneself whether the whole business cycle accounting approach is appropriate. It just looks like a big misspecification waiting to happen.

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