Daniel Ahelegbey

Blanca Ballesta
Ruhollah Eskandari
MONETARY POLICY.

Problem Set 1
We will examine the business cycle properties of real GDP.

We examine and compare the data for 2 monetary regimes: before the EMU and after de
EMU.

Prior to our empirical analysis, we must extract the cyclical component from the
macroeconomic time series. We use the hodrick prescot filter.

The Hodrick-Prescott (HP) filter estimates an unobserved time trend for time series
variables.

Let yt denote an observable (macroeconomic) time series. The HP filter decomposes yt

into a nonstationary time trend (gt) and a stationary residual component (ct), that is:
yt = gt + ct

After extracting the cyclical component we know focus in examining the length of the
cycle in the two periods in consideration: before the EMU and afterwards.

We consider as a starting point of the EMU the 1 st January of 2001. the economic and
monetary union of the European Union is the currency union (built on a single market) of
the European Union members who have adopted the euro as their sole legal tender. Full
economic and monetary union has been in effect since 1 January 2002 for twelve
countries, with further members joining since. For the European Union, economic and
monetary union (EMU) was established in three phases: coordinating economic policy,
achieving economic convergence (that is, their economic cycles are broadly in step) and
culminating with the adoption of the euro. (The initial participants were Belgium,
Germany, Spain, France, Ireland, Italy, Luxembourg, the Netherlands, Austria, Portugal and
Finland). The number of participating Member States increased to 12 on 1 January 2001,
when Greece entered the third stage of EMU. Slovenia became the 13th member of the
euro area on 1 January 2007, followed one year later by Cyprus and Malta and by Slovakia
on 1 January 2009.
1. Length of the cycle.

We take each country GDP series before 2001 and after 2001 and calculate the length of
the cycle in the two periods.

The data we take is quarterly data from 1991Q1 to 2009Q4 (from EUROSTAT “GDP and
main components - Current prices (namq_gdp_c))”. So we have 2 time series for each
country composed by 40 and 36 observations respectively.

Table 1
Average Length (years) of Business Cycles under Different Monetary Regimes
Period Austria Germany Spain Italy Belgium Netherlands
BEFORE
5.25 5.25 5.75 5.25 4.75 4.5
EMU
AFTER
4 3.5 5 4 4.75 3.75
EMU
Note: The Before EMU period is considered from 1991 to 2000 (last quarter) and the After EMU
period consider data from 2001 until 2009 (last quarter).

We can see clearly that in every country the length of the cycle have been reduced (except
for Belgium where remains constant). This can be explained due to the stabilization policy
that the ECB has been practicing in order to get the price stability which is the main target
of the ECB monetary policy. But, we cannot claim that the reduction of the length has been
due to the creation of the Eurozone, it can be due to many others factors.

So now, we pass to analyze the volatility of the cycle and of some monetary variables to
see whether the change of the monetary policy (introduced by the ECB after the EMU) has
really affected the business cycles.

2. Volatility of the cycle

The study examined the volatility of the filtered data by comparing the volatility of the
cyclical component of GDP and aggregate prices pre and post EMU. The table below
shows the result of the Volatility and Skewness of Hodrick -Prescott-Filtered GDP and
Prices Pre and Post EMU.

Volatility and Skewness of Hodrick -Prescott-Filtered GDP and Prices Pre and Post
EMU

Table 2 ENTIRE PERIOD PRE – EMU POST – EMU

1995 - 2009 1995 – 2000 2001 - 2009
Std. Dev Skewness Std. Dev Skewness Std. Dev Skewness
Austria 0.00556 0.185685 0.002799 0.365313 0.003533 0.341445
Belgium 0.007114 0.027529 0.003125 0.651721 0.004447 -0.1249
Germany 0.005565 0.500893 0.00196 -0.18247 0.00453 0.203107
Italy 0.008288 -0.76138 0.005978 -0.74838 0.003459 -0.24827
Netherlands 0.009103 -0.22513 0.004399 0.46624 0.004426 0.14802
 Spain 0.009103 -0.22513 0.004399 0.46624 0.004426 0.14802
M3 0.059545 -0.41794 0.037133 -0.29865 0.030179 0.1233
Price_Aust 0.033704 0.198768 0.009964 0.059402 0.021697 0.133896
Price_Belg 0.036791 0.221331 0.011785 0.082388 0.024273 0.191961
Price_Germ 0.02783 0.223073 0.009406 -0.27631 0.018532 0.240807
Price_Italy 0.042768 -0.05773 0.017639 -0.39067 0.02452 -0.059
Price_Neth 0.041297 -0.19771 0.016167 0.093381 0.019446 -0.18556
Price_Spain 0.055037 0.093027 0.018722 0.042135 0.034067 -0.06075

The result obtained indicates that volatility (standard deviation) has not changed
significantly over the period. Indications are that volatility of the cyclical component of
GDP is somewhat higher for countries like Austria, Belgium, Germany and The
Netherlands during the post EMU than in the pre EMU whilst that of Italy has fallen
over the period. In terms of prices, the volatility is somewhat higher for all countries
studied during the post EMU than in the pre EMU.

The table below shows the Relative Volatility of Prices and GDP Pre and Post EMU.
Observation from the results obtained indicates that the relative volatility of prices to
GDP is higher for all countries studied during the post EMU than in the pre EMU. This
result however asserts that prices are more volatile than GDP especially during the post
EMU.

Relative Volatility of Prices and GDP Pre and Post EMU

Table 3 ENTIRE PERIOD PRE – EMU POST – EMU

1995 – 2009 1995 – 2000 2001 - 2009
Austria 6.0618705 3.5598428 6.1412397
Belgium 5.1716334 3.7712 5.4582865
Germany 5.0008985 4.7989796 4.0909492
Italy 5.1602317 2.9506524 7.088754
Netherlands 4.5366363 3.6751534 4.3935834
Spain 6.0460288 4.2559673 7.6970176
3. Formal Test for the Declining of the Volatility over Time

To construct a formal test of the hypothesis that volatility measured by the variance of the
HP-filtered GDP declined over time, we used a Seemingly Unrelated Regression (SUR)
system with applied volatility (in terms of conditional variance) of the HP-filtered GDP as a
dependent variable in this model.

Volatility, as measured by the standard deviation of a series is constant for a given sample,
however it changes through time. Time-varying conditional variances are measured by the
autoregressive conditional heteroskedasticity models.

For estimating volatility we followed the Hansen and Lunde (2001) that compared a large
number of volatility models in terms of their ability to describe the conditional variance
and found that performance of this model seems to be better than the others.

According to reference paper we used a Seemingly Unrelated Regression (SUR) system

with 8 equations to construct a formal test of the hypothesis that volatility measured by
the conditional variance of the HP-filtering GDP declined over time. Generally a SUR
representation is:

In this case independent variable is a dummy variable that has the value one for period
before introduction and zero after it. In this model, coefficient on the dummy variable is a
measure of the conditional variance of the business cycle. To test whether the variance is
constant for each country separately and also test the joint hypothesis that the variance is
constant for all countries simultaneously, we used Wald tests. As Table?, shows that this
hypothesis can be rejected for each country by itself, that is, we reject constant variance
for whole 8 cases and joint test covering all countries also rejects this hypothesis at very
high significant levels (99%). Formal test results confirmed previous results in the table 2
indicating that volatility (in terms of standard deviation) increased after EMU for all
countries except Italy (Declined) and Spain (no change).
 Table 4

Wald Tests of the Hypothesis That the Conditional Variance of the Cyclical
Component of Real GDP Is Constant before and after introduction.

Country by Country
Belgium Germany Luxemburg Netherlands
Wald test 6.80 21.90 66.10 121.63
P-value 0.0000 0.0000 0.0000 0.0000
Portugal Slovakia Slovenia Spain
Wald test 23.84 17.62 89.68 26.47
P-value 0.0000 0.0000 0.0000 0.0000
All 8 countries

Wald test 279.26

P-value 0.0000

4. The Behavior of Economic Aggregates before and after EMU

To characterize the behavior of the economic aggregates for whole period and tow sub-
periods we used an OLS regression model to study the effects of deviations from trend
of economic aggregates on deviations from trend of real GDP. As the results shown in
the Tables 5, 6 and 6 we cannot state that cyclical component of money affects the real
business cycles in the analyzed countries of the Eurozone. Of course, applying an OLS
model with this case couldn’t satisfy classical hypothesis for correlation and multi-
colinearity but we followed the reference paper.

Table 5

Effects of HP-Filtered Economic Aggregates on Real GDP for Whole Period (1995Q1-2009Q4)

Durbin-
Variable C I X M M2 R2 Watson
stat

Coefficien
1.058431 1.069213 1.003056 1.045010 0.000316 0.999836 1.736418
t
Std. Error 0.018660 0.031311 0.023468 0.028645 0.000164
0.0000** 0.0000** 0.0000**
Prob. 0.0000*** 0.0589*
* * *
* The parameter is statistically significant at the 10% significant level.
*** The parameter is statistically significant at the 1% significant level.
Table 6

Effects of HP-Filtered Economic Aggregates on Real GDP before EMU (1995Q1-2001Q4)

Variable C I X M M2 R2 DW

Coefficien
t 1.076347 1.087873 0.992599 1.041566 0.000647 0.999704 1.709563
Std. Error 0.028353 0.047564 0.051920 0.051714 0.000787
0.0000** 0.0000** 0.0000**
Prob.
* * * 0.0000*** 0.4199
*** The parameter is statistically significant at the 1% significant level.

Table 7

Effects of HP-Filtered Economic Aggregates on Real GDP after EMU (2001Q1-2009Q4)

Variable C I X M M2 R2 DW

Coefficien
t 1.056355 1.048446 0.994946 1.057966 1.057966 0.999869 1.641064
Std. Error 0.027772 0.049324 0.031973 0.040877 0.000196
0.0000** 0.0000** 0.0000**
Prob.
0.0000*** * * * 0.0665*
* The parameter is statistically significant at the 10% significant level.
*** The parameter is statistically significant at the 1% significant level.

References

1. Bergman, U.M., Bordo, m.d. and Jonung, L (1998). HISTORICAL EVIDENCE ON

BUSINESS CYCLES: THE INTERNATIONAL EXPERIENCE.
2. Hansen, P.R. and A. Lunde (2001). A comparison of volatility models: does anything beat a
GARCH(1,1) model? Brown university working paper. Journal of Applied Econometrics 4:
S145–S159.
3. Burns and Mitchell (1946) “Constant gain learning and business cycles”
4. Robert J. Hodrick, Eduard C. Prescott (1997) US Business Cycles: An empirical investigation.