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chapter
The Changing Dynamics of the Global
Business Cycle
World growth in recent years has been much more and that the current global expansion will con-
rapid than at any time since the oil price surges of tinue for a long time? Or is the recent stability
the 1970s. This growth is being shared across coun- likely to come to an end?
tries to an unprecedented degree. Moreover, output This chapter aims to shed light on these
volatility in most countries and regions has signifi- questions in two separate ways. First, it compares
cantly declined. This chapter analyzes these changes the current global growth cycle with earlier
in business cycle characteristics and finds that the periods, including the 1960s—a previous era
increasing stability and the associated increase in the of strong growth and low volatility. Second, the
durability of expansions largely reflect sources that are chapter analyzes the sources of differences,
likely to prove persistent. In particular, improvements both across countries and over time, in busi-
in the conduct of monetary and fiscal policy, as well ness cycle characteristics such as output volatil-
as in broader institutional quality, have all reduced ity and the length of expansions. It follows the
output volatility. The prospects for future stability recent literature on the “Great Moderation” in
should, however, not be taken for granted. Low aver- the U.S. economy, but extends the analysis to a
age volatility does not mean that the business cycle is global context. Further, it focuses on determin-
dead. The abrupt end to the period of strong and sus- ing to what extent policy actions have helped to
tained growth in the 1960s and early 1970s provides bring about an enduring reduction in volatility
a useful cautionary lesson about what can happen so as to make expansions more durable.
if policies do not adjust to tackle emerging risks in a This chapter finds that, in important ways, the
timely manner. global economy has recently displayed greater
F
stability than observed even in the 1960s. In
rom 2004 to the present, the world econ- particular, the volatility of output has declined
omy has enjoyed its strongest period of in most countries, and growth is more broadly
sustained growth since the late 1960s and shared across countries than previously
early 1970s, while inflation has remained observed. Further, the chapter suggests that the
at low levels. Not only has recent global growth increase in the durability of expansions largely
been high but the expansion has also been reflects sources that are likely to prove persis-
broadly shared across countries. The volatility tent, including improvements in the conduct of
of growth has fallen, which may seem especially monetary and fiscal policy, as well as in broader
surprising because the more volatile emerging institutional quality.
market and developing countries account for a The prospects for future stability, however,
rising share of the global economy. should not be taken for granted. Low average
How much of the recent performance of the volatility does not rule out occasional recessions.
global economy is a result of good policies, solid More broadly, the abrupt end to the period
institutions, and structural changes, and how of strong and stable growth in the 1960s and
much is pure “good luck”? Can policymakers be early 1970s provides a cautionary tale of what
confident that output volatility will remain low can happen if policies do not respond to risks
and new challenges in the global economic sys-
tem as they arise. The Bretton Woods system of
Note: The main authors of this chapter are Martin fixed exchange rate parities worked well for an
Sommer and Nikola Spatafora, with support from Angela
Espiritu and Allen Stack. Massimiliano Marcellino pro- extended period. In the end, however, it did not
vided consultancy support. prove sufficiently resilient as imbalances from
67
Chapter 5 The Changing Dynamics of the Global Business Cycle
68
Global Business Cycles: A Historical Perspective
1922–38
In 1947–73
this chapter, expansions are defined as periods of Japan 1974–82
nonnegative growth of real GDP per capita. Analogously, 1983–2002
recessions are defined as periods of falling real GDP per Current cycle
capita. Most analysis in this chapter therefore adopts the 1947–73
concept of the “classical” business cycle as discussed in, 1974–82
NIEs 1983–year 2
for example, Artis, Marcellino, and Proietti (2004) and Current cycle
Harding and Pagan (2001)—see Appendix 5.1 for details.
Expansions are identified using annual data and in per 1947–73
China 1974–82
capita terms to allow for broad comparisons across coun- 1983–2007
tries and over time. Expansions based on quarterly data
1870–1914
would likely be shorter for many countries. There are also 1922–38
notable differences in cyclical behavior within regions: India 1947–73
for example, the United Kingdom has not experienced a 1974–82
1983–1991
recession since 1991 based on this chapter’s definition of Current cycle
business cycles.
The stabilization of post–World War II business cycles Algeria, Egypt, 1947–73
Nigeria, and 1974–82
relative to the pre-war period has been attributed to a South 1983–year 2
number of factors, including higher average growth rates; Africa Current cycle
lower share of commodity-linked sectors; introduction of 1870–1914
deposit insurance, which reduced the number of banking Argentina, 1922–38
panics; and the pursuit of macroeconomic stabilization 1947–73
Brazil, Chile,
1974–82
policies—although at times policy mistakes destabilized and Mexico 1983–year 2
output (Romer, 1999). In the academic literature, there is Current cycle
a vigorous debate about the quality of pre-war GDP data I.R. of Iran,
1947–73
and the nature of pre-war cycles; see Balke and Gordon Kuwait, Saudi 1974–82
Arabia, and 1983–year 2
(1989); Diebold and Rudebusch (1992); and Romer United Arab Current cycle
(1989) for a detailed discussion. Emirates
See Romer and Romer (2002) and DeLong (1997) for 0 5 10 15 20 25 30
a discussion of U.S. monetary policy during the 1970s.
Broadly, monetary policy was too accommodative during Sources: Heston, Summers, and Aten (2006); Maddison (2007); World Bank, World
the period, partly reflecting unrealistically low estimates Development Indicators database (2007); and IMF staff estimates.
1Expansions are defined as periods with nonnegative annual real GDP per capita growth.
of the natural rate of unemployment. The eventual See Appendix 5.1 for details. Data for country groups refer to group medians. The current
tightening of monetary policy in response to double- cycle includes the expected outcome for 2007.
2The period starting in 1983 ends as follows: Europe: France (1993), Germany (2003),
digit inflation caused a recession in the early 1980s.
Italy (2005), and the United Kingdom (1991); NIEs: Hong Kong SAR (2001), Korea (1998),
Orphanides (2003b) suggests that incomplete real-time Singapore (2003), and Taiwan Province of China (2001); Africa: Algeria (2002), Egypt
information about the economy may have increased the (1997), Nigeria (2004), and South Africa (1992); Latin America: Argentina, Brazil, Mexico
(2002), and Chile (1999); and Middle East: I.R. of Iran (2001), Kuwait (2002), Saudi
likelihood of policy mistakes in the 1970s, especially in Arabia (2002), and the United Arab Emirates (1998).
the period of difficult-to-observe productivity slowdown.
69
Chapter 5 The Changing Dynamics of the Global Business Cycle
70
Has the World Economy Become More Stable?
vulnerabilities—for example, the losses associ- vidual countries therefore tended to offset one
ated with highly leveraged investments in the another to a greater degree during the 1960s.
U.S. subprime mortgage market have created The evolution of output volatility over time
distress in the banking sector in many advanced can be broken down into several phases. In
economies, raising concerns about a possible advanced economies, volatility was high in
credit crunch (see Chapter 1). Looking beyond the 1950s, partly as a result of the boom-and-
the most recent market developments, the bust cycle associated with the Korean War and
policy debate has also focused on the potential the rapid, but volatile, post-war reconstruction
risks arising from global imbalances or the link- phase in Europe and Japan (Figure 5.4; output
ages between monetary and prudential policies volatility during the 1950s is captured by the
and sustained asset price booms. For example, data point for 1960). Volatility declined dur-
White (2006) suggests that successful inflation ing the 1960s, but it rose again in the 1970s as
targeting may have led to increased vulnerability a result of oil supply disruptions and stop-go
of economies to an excessive buildup of asset macroeconomic policies. After the disinflation
prices. of the early 1980s, volatility in advanced econo-
mies began to fall in a sustained way and is cur-
rently only about one-half of that seen during
Has the World Economy Become the 1960s.
More Stable? Volatility has also fallen over time in emerging
One important business cycle characteristic market and developing countries, although this
is output volatility. Together with the trend decline occurred much later than in advanced
growth rate, volatility determines the amount economies. Looking at the performance of
of time that economies spend in expansions or developing regions by decades, output volatil-
recessions. The volatility of global growth, as ity varied greatly during the 1960s, with some
measured by the rolling 10-year standard devia- countries, such as those in Latin America,
tion of world GDP growth (PPP weighted), has experiencing a relatively stable period, while
fallen progressively since its 1970s peak. The others, notably China, experienced high volatil-
standard deviation of world output growth over ity.10 Oil shocks, increases in other commodity
the past 10 years has been 0.9 percent, which prices, and spillovers from advanced economies
is only slightly lower than during the 1960s— increased output volatility in most emerg-
another period of strong and sustained growth. ing market and developing countries during
This outcome at the aggregate level, however, the 1970s. Unlike in the advanced economies,
masks a more substantial, one-third reduc- however, volatility stayed high or increased fur-
tion in volatility at the country level between ther during the 1980s and much of the 1990s as
the 1960s and the present—the standard devia-
tion of median country growth declined from See Box 4.3 in the April 2007 World Economic Outlook.
3.8 percent to 2.7 percent (see Figure 5.1). The Data limitations do not allow a comprehensive analysis
different degrees of volatility moderation at the of volatility in developing countries in the 1950s. Specifi-
cally, volatility of growth cannot be reliably calculated
world and country levels arise because growth for many countries in Africa, Asia, and the Middle East
outcomes were less correlated across countries because the available GDP data are often interpolations
in the 1960s owing to more limited trade and among infrequent benchmark estimates and, therefore,
annual growth rates tend to be smoothed. In Latin
financial linkages. Output fluctuations of indi-
America (for which more accurate data are available),
output volatility was higher than in advanced economies
during the decade (see Figure 5.4).
10The extremely high volatility of the Chinese economy
The 10-year window was chosen because the length of was, to a large extent, caused by the Great Leap Forward
a typical cycle in advanced economies increased to about economic plan and the Cultural Revolution (launched in
10 years during the 1980s and 1990s. 1958 and 1966, respectively).
71
Chapter 5 The Changing Dynamics of the Global Business Cycle
Figure 5.4. Volatility of Growth in the Main World countries were buffeted by debt crises (especially
Regions1 in Latin America and Africa) and banking and
(Rolling 10-year standard deviations of detrended growth—year 1960 currency crises (in Asia, central and eastern
represents volatility over 1951–60)
Europe, and Latin America). Some countries
Advanced economies quickly stabilized after the oil shocks of the 1970s. Their also experienced high volatility during their
volatility is now about one-half of their levels in the 1960s. Output stabilization was
transition from centrally planned to market
more gradual and modest in emerging market and developing countries, as many
economies experienced debt, currency, and banking crises. economies.11 Despite a big decline in recent
Volatility of Volatility of detrended Upper and lower
years, the output volatility in developing econo-
detrended growth growth for median country quartiles mies continues to be significantly higher than
8 Advanced Economies Emerging Market and 8 in advanced economies, partly as a result of
Developing Countries
structural differences, such as the greater weight
6 Year 1960 represents 6
volatility over 1951–60 of agriculture or commodity-related sectors. The
median standard deviation of annual growth
4 4
is currently 3 percent in emerging market and
2 2 developing countries compared with 1¼ percent
in advanced economies.
0 0 Volatility decompositions suggest that most of
1960 70 80 90 2000 1960 70 80 90 2000
the past changes in the volatility of world growth
8 United States China and Developing Asia 10
can be attributed to advanced economies, espe-
China 8
6 Developing cially the United States (Figure 5.5).12 That said,
Asia
6 falling output volatility in China contributed
4 noticeably to the lower volatility of world growth
4
during 1996–2006 compared with 1983–95.
2
2
ASEAN-4
0 0 11In central and eastern Europe, deep recessions associ-
1960 70 80 90 2000 1960 70 80 90 2000
ated with the transition from centrally planned to market
8 EU-15 Latin America 8 economies generated very large output volatility during
the 1990s. Countries of the former Soviet Union are not
6 6 included in the analysis because many variables for these
countries are not readily available for the period prior to
4 4 the 1990s. See Chapter 2 in the April 2005 World Economic
Outlook for a detailed discussion of output volatility in
developing countries.
2 2 12Decompositions of volatility in this section are carried
72
Has the World Economy Become More Stable?
Despite the fact that emerging market and Figure 5.5. Decomposition of Changes in World Output
developing countries tend to be more volatile Volatility by Region1
than advanced economies, their growing weight (Variance of real GDP growth)
has so far not pushed world output volatility
Volatility of world growth was particularly high during 1974–82, a period
higher, mostly because output volatility in China characterized by oil supply disruptions and policy swings. At the aggregate level, the
moderation of world volatility has been fairly small compared with 1960–73,
is now as low as in advanced economies.13 although since then many countries have experienced significant reductions in
Figure 5.5 also suggests that the comovement volatility (see Figure 5.4). Greater trade and financial integration have increased the
correlation of growth across countries, and this has largely offset the decline of
(covariance) of growth across countries is an volatility at the country level. Most of the past changes in world output volatility can
important factor affecting volatility of world be attributed to advanced economies, especially the United States.
output. The simultaneity of growth decelerations
Decomposition by Region 3.5
after the oil price shocks of the 1970s illustrates United States Latin America Rest of world
EU-15 2 China Contribution of covariance 3.0
how rising covariance can at times magnify the Other advanced Other developing Asia2
2
impact of country volatility on the volatility economies 2.5
EU-15
Region
Changes in covariance
covariance
Further decompositions of world output -0.5 -0.4 -0.3 -0.2 -0.1 0.0 0.1 0.2 0.3
Other advanced
rise in overall volatility during 1974–82 was to a economies
large extent due to the rise in investment volatil- Rest of world
Changes in covariance
covariance
due to variance3
Changes in covariance
due to correlation3
13If the current world volatility were recalculated using
73
Chapter 5 The Changing Dynamics of the Global Business Cycle
Figure 5.6. Decomposition of Changes in World Output the period was characterized by repeated supply
Volatility by Expenditure Component1 disruptions, shifts in productivity trends, and
(Variance of real GDP growth) policy swings, all of which induced volatility in
the expected profitability of investment plans.
Consumption and investment volatility have both shifted significantly over time. The Nevertheless, the decline in world output volatil-
rise in overall volatility during 1974–82 was, to a large extent, due to the rise in
investment volatility, as supply disruptions, shifts in productivity trends, and policy ity from the 1960s to the present is attribut-
swings induced volatility in investment plans. The mild decline in world output able mostly to lower volatility of consumption
volatility from the 1960s to the present is mostly attributable to the lower volatility of
consumption. rather than investment. Some of this latter
result is certainly driven by the nature of events
Decomposition by Expenditure Component 3.0 unfolding over the past decade, including a
Private consumption
significant reduction of investment in post-crisis
2.5
Investment and post-bubble economies. Indeed, volatility of
Government expenditure 2.0
Net exports investment was somewhat lower during 1983–95
Contribution of covariance
1.5 compared with the past decade. The finding,
however, suggests that any explanations for the
1.0
current output stability need to include factors
0.5 that affect consumer behavior, such as the rising
0.0 availability of financing to smooth consumption
1960–73 1974–82 1983–95 1996–2006
over time.15
Looking in more detail at the United States
Change from 1960–73 to 1996–2006
(Figure 5.7), the decline in output volatility
Consumption
Component
Government
Investment
by consumer behavior (through a variety of
Net exports channels, including lower volatility of consumer
spending, residential investment, and lower
Contribution of
Changes in covariance
covariance
Government
data. While the aggregate world data do not identify
Investment government expenditures as the major source of output
Net exports volatility, fiscal policy in the form of, for instance, procy-
clical spending or excessive debt accumulation has been
Contribution of
Changes in covariance
a significant driver of output volatility in many countries
covariance
due to variance 2
Changes in covariance (see the next section). These country-specific effects,
due to correlation 2 however, disappear in the aggregate world data.
16During the 1960s, government expenditures
Total increased U.S. output volatility through volatile defense
-2.5 -2.0 -1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 spending associated with the Vietnam War.
17Several studies have highlighted the contribution of
Sources: Heston, Summers, and Aten (2006); World Bank, World Development Indicators improved inventory management techniques and lower
database (2007); and IMF staff calculations. volatility of inventory investment to the reduction of
1 Volatility is measured as the variance of real purchasing-power-parity-weighted GDP
quarterly output volatility in the United States since the
growth over a period. Given data limitations, world output volatility cannot be reliably 1980s (McConnell and Perez-Quiros, 2000; and Kahn,
calculated for the 1950s.
2 Contributions of covariance to the changes in output volatility were decomposed into McConnell, and Perez-Quiros, 2002). However, the role
contributions due to changes in the variance of expenditure components and changes in the of inventories is greatly diminished in the annual data,
correlation among them. See Appendix 5.1 for details. especially when considering volatility changes between
74
Has the World Economy Become More Stable?
although—for the same reasons as at the world Figure 5.7. Decomposition of Changes in U.S. Output
level—the lower volatilities of inventories and Volatility1
business fixed investment have contributed to (Variance of real GDP growth)
the moderation of U.S. output volatility relative
to the 1970s. The decline in U.S. output volatility since the 1960s has been driven largely by
consumer behavior, including through lower volatility of consumer spending,
Looking forward, the performance of emerg- residential investment, and the lower correlation between consumption and
ing market and developing countries will be investment. Lower volatility of government spending also explains some of the
volatility moderation between 1960–73 and 1996–2006.
increasingly important for the stability of the
world economy. In 2006, these economies
Decomposition by Expenditure Component 14
accounted for over 40 percent of global GDP, Private consumption Government expenditure
Residential investment Exports 12
two-thirds of world GDP growth (using PPP
Inventory investment Imports
10
weights), and about one-third of world trade Fixed investment Contribution of covariance
(at market exchange rates). China and India 8
economies that experienced rapid expansions 1947–59 1960–73 1974–82 1982–95 1996–2006
-2
earlier, although China has been able to main-
tain extremely high growth for a longer period Change from 1960–73 to 1996–2006
Consumption
of time than Japan and the NIEs (including
Government
Korea), the previous best performers during the
Component
Residential investment
variance
Changes in covariance
volatility than world growth. As the economies due to variance 2 Lower correlation
diversified away from volatile sectors such as Changes in covariance between consumption
due to correlation 2 and investment
agriculture and the policy frameworks improved,
Total
their output volatility started to converge to the
-6 -5 -4 -3 -2 -1 0 1
world average. But these historical comparisons
also offer some cautionary tales. Brazil and Change from 1974–82 to 1996–2006
Mexico were not able to sustain high growth Consumption
Government
as structural rigidities became binding, and
Component
Residential investment
variance
Changes in covariance
the 1960s and today. From a policy perspective, changes due to variance 2
in the quarterly fluctuations of inventory investment may Changes in covariance
not have important welfare implications unless these due to correlation 2
have a significant longer-lived impact on, for example, Total
consumption growth—which appears unlikely. Another -6 -5 -4 -3 -2 -1 0 1
aspect influencing the interpretation of any volatility stud-
ies based on quarterly data is that components of quar-
terly national accounts tend to suffer from much greater Sources: U.S. Bureau of Economic Analysis; and IMF staff calculations.
1Volatility is measured as the variance of real GDP growth over a period.
measurement error than annual data; for example, Som- 2Contributions of covariance to the changes in output volatility were decomposed into
mer (2007) documents that measurement errors make up contributions due to changes in the variance of expenditure components and changes in
a nontrivial fraction of quarterly consumption growth. the correlation among them. See Appendix 5.1 for details.
75
Chapter 5 The Changing Dynamics of the Global Business Cycle
76
What Is Driving the Moderation of the Global Business Cycle?
Over the past five years, the world economy Output Comovement with Major Economies,
has enjoyed the highest growth since the early by Region1
1970s, despite a significant slowing of the U.S. (Averages by region)
economy since 2006 and, earlier, a sluggish United
recovery in the euro area and Japan. Some States Germany Japan India China
observers have argued that the apparently All countries
1960–73 0.00 0.07 0.03 0.03 0.07
reduced spillovers could mean that the world 1996–2006 0.24 0.23 0.23 0.06 0.20
economy has become more robust to distur- Industrial countries
bances in major economies, partly because, with 1960–73 0.07 0.35 0.25 0.08 0.05
1996–2006 0.54 0.74 0.03 0.04 0.14
new poles such as China and India, there are Latin America
more sources of growth to pick up the slack. 1960–73 0.02 0.09 0.05 0.02 0.13
At the same time, however, the scope for 1996–2006 0.26 0.28 0.44 0.15 0.43
Emerging Asia
cross-country spillovers from disturbances in 1960–73 –0.04 0.08 0.05 –0.07 0.16
major economies has increased with rapidly 1996–2006 0.17 0.06 0.49 0.06 0.25
rising cross-border trade and financial linkages, Africa
1960–73 –0.05 0.04 –0.02 0.05 0.03
which could at least partly offset these econo- 1996–2006 0.11 0.03 0.16 0.05 0.16
mies’ declining share of global trade growth.
Source: IMF staff calculations.
Against this background, this box compares 1The table reports regional averages of bilateral correlation
recent patterns of business cycle comovement coefficients with the major economy indicated. Correlations are
for China and India with those of major indus- based on annual growth rates. The regional classification of
countries follows that used in Chapter 2.
trial countries and analyzes the impact of distur-
bances in major economies on global growth in
a general framework. noticeable for countries in Latin America and
Turning first to the experience with inter- emerging Asia.
national business cycle comovement, the first • In industrial countries, comovement with the
table reports the extent of output correlations United States and Germany increased sharply
between major economies and different regions between 1960–73 and 1996–2006, whereas it
for 1960–73 (a period with limited cross-border decreased with Japan.
linkages and, unlike the 1970s and early 1980s, • In other emerging market and developing
no large global disturbances) and 1996–2006, a countries, and particularly in Latin America,
period with rapidly rising cross-border linkages. comovement with the United States and
Three findings stand out. Japan increased.
• Business cycle comovement with the new Using the correlations as rough approximations
poles indeed increased in the second period for cross-border spillover effects of disturbances,
compared with the first one. The rise is the results suggest that a disturbance to growth
particularly evident for China. Increased in China could now have substantial spillover
comovement with the new poles is particularly effects on some emerging market and develop-
ing countries, although the effects on industrial
countries would be considerably smaller.
Overall, the picture that emerges is one of
Note: The main author of this box is Thomas
Helbling. increasing business cycle comovement, first,
The box draws on Chapter 4 of the April 2007 among industrial countries and, second, among
World Economic Outlook. China and emerging market economies in Latin
See Box 4.3 in the April 2007 World Economic
America and Asia. In contrast, business cycle
Outlook on the measurement of international business
comovement between industrial countries and
cycle synchronization. The comparison between the
1960s and more recent periods follows Kose, Otrok, other emerging market and developing coun-
and Whiteman (2005). tries has risen by less.
77
Chapter 5 The Changing Dynamics of the Global Business Cycle
What are the main factors determining the Exports to Major Economies, by Region
impact of disturbances in a major economy (In percent of total exports; averages by region)
on international business cycles and ultimately Exports to
global growth? Three seem particularly rele- United
vant. First, the size of a country’s GDP matters, States Germany Japan India China
both directly, through its own impact on global Exports from
growth, and indirectly, through the impact on All countries1
1973 17.5 7.4 6.1 0.5 0.8
other countries. For given trade shares, a larger 2006 16.0 5.3 3.8 2.3 6.0
importer will have a greater effect on other Industrial countries
countries’ external demand (or, in other words, 1973 12.5 11.6 4.3 0.3 0.5
2006 11.9 12.6 2.9 0.8 2.9
export exposure) as a percent of GDP. In this Latin America
regard, China has now surpassed most major 1973 37.8 7.4 4.0 0.1 0.3
industrial countries in terms of its share in 2006 27.6 1.7 1.6 0.4 2.6
Emerging Asia
global GDP and global imports, whereas India’s 1973 15.1 3.5 15.0 0.7 1.3
economic size is still relatively small. More gen- 2006 11.9 4.1 6.9 5.9 8.6
erally, the total share of the largest 10 econo- Africa
1973 11.1 7.1 3.5 0.6 1.1
mies has remained broadly unchanged since 2006 10.3 3.4 2.7 3.3 8.7
the early 1970s, in terms of both global GDP
Sources: IMF, Direction of Trade Statistics; and IMF staff
and world imports. From this perspective, the calculations.
scope for other major economies to pick up the 190 countries.
(2004, 2006); and Baxter and Kouparitsas (2005). See Moneta and Rüffer (2006).
78
What Is Driving the Moderation of the Global Business Cycle?
conditions. Indeed, financial contagion and Against this backdrop, the broad decoupling
the attendant financial crises during the late of Japan from other industrial countries in the
1990s may be one factor behind the increased late 1990s is not surprising because develop-
business cycle comovement among emerging ments in the Japanese economy at the time
market countries. were country specific—protracted adjustment
Third, the nature of disturbances plays an after a major asset price boom-bust cycle—with
important role. Disturbances in a major economy limited apparent global financial market
tend to have limited cross-border spillover effects impact.10 Similarly, because the current U.S.
if they are specific to the country or if they are slowdown has been driven by sector-specific
transmitted primarily through trade channels. developments—primarily in housing but also
• Regarding the reach of disturbances, past in manufacturing—with limited impact on
episodes with large declines in growth across broader asset markets until very recently, the
countries at the same time were characterized spillover effects on growth in other countries
by common disturbances that were either outside the region have generally remained
truly global in nature (e.g., abrupt oil price small so far.
changes) or were correlated across countries In sum, the seemingly limited impact of dis-
(e.g., disinflationary policies during the early turbances in major economies on global growth
1980s). in the current episode to date reflects a number
• As for the limited effects of disturbances of factors, including the nature of the slow-
transmitted through trade channels, the main down in the United States. The new poles likely
reason is that, except for countries in the have played a role as well, primarily through
same region, the effects on external demand the direct impact of their high growth rates on
are usually small in terms of overall demand. global growth and their impact on commodity
In contrast, spillovers tend to be larger if prices (which has benefited many emerging
asset price and/or confidence channels are market and developing countries), but also
involved. In this respect, with the continued through their impact on growth in emerging
dominant role of the United States in global Asia and Latin America. Nevertheless, with
financial markets, cross-border spillovers from financial markets around the world now being
financial shocks in the United States remain a affected by the fallout from U.S. subprime mort-
particular concern. gage difficulties, a broader growth slowdown
cannot be ruled out.
See also Kose, Otrok, and Prasad (forthcoming).
See the April 2007 World Economic Outlook.
See, among others, Bayoumi and Swiston (2007); 10See, for example, Helbling and Bayoumi (2003);
and Ehrmann, Fratzscher, and Rigobon (2005). and Stock and Watson (2005).
could explain changes in business cycle char- more difficult and, in the extreme, may
acteristics (see Appendix 5.1 for details). The encourage coups and revolutions.21
variables include the following:
• Institutional quality. Broadly understood, this 21Institutional quality is captured here by a measure
can increase a country’s capacity to reconcile of constraints on the political executive. Among other
advantages, this variable is available for a broad sample
internal political differences. In turn, greater of countries and for extended periods; it also seems less
political stability and continuity in policymak- prone to endogeneity problems than other indicators,
ing may foster economic stability and sustain- such as the ICRG risk measures. See Acemoglu and oth-
ers (2003); and Satyanath and Subramanian (2004) for a
ability. More specifically, weak institutions may fuller discussion of this variable and of how institutions
render adjustment to major economic shocks in general may affect volatility.
79
Chapter 5 The Changing Dynamics of the Global Business Cycle
Figure 5.9. Some Determinants of Differences in • The quality of macroeconomic policies. In part,
Business Cycle Characteristics1 this is assessed through an index measuring
(Unweighted averages) the success of the monetary framework in
maintaining low inflation (see Box 5.2 for
Monetary policy improved substantially in advanced economies after the 1970s;
more recently, significant improvements have occurred in emerging market and an assessment of the extent to which better
developing countries as well. Since the 1980s, the volatility of fiscal policy has monetary policies and more flexible markets
declined in most advanced economies, institutional quality has increased in most
emerging market and developing countries, and terms-of-trade volatility has have muted the business cycle in the United
declined sharply in both advanced economies and developing countries. For all States).22 In addition, more stable fiscal policy
these variables, advanced economies score more favorably than emerging market
and developing countries. can help dampen, or at least not amplify, out-
8
put fluctuations; in this context, the analysis
Institutional Quality Index 2
(maximum = 7; minimum = 1) Advanced economies 7
focuses on the volatility of cyclically adjusted
6 government expenditures.23 As mentioned
World 5 above, external vulnerabilities have in the
4 past also brought expansions to a premature
Emerging market and
3 end. Therefore, the impact of large current
developing countries
2 account deficits (defined here as a deficit
1960 65 70 75 80 85 90 95 2000 05
exceeding 5 percent of GDP) is also analyzed.
Monetary Policy Index 3 1.2 • Structural features. For instance, a better-
(maximum = 1; minimum = 0) Advanced economies developed financial infrastructure (measured
1.0
using the ratio of private sector credit to GDP)
0.8
World may enable greater smoothing of both con-
0.6
sumption and investment plans.24 Other struc-
Emerging market and 0.4 tural factors, including changes in the sectoral
developing countries
0.2 composition of output, improved inventory
1960 65 70 75 80 85 90 95 2000 05
management techniques in the wake of the
Volatility of Fiscal Policy 4 Emerging market and 3.0 information technology revolution, more flex-
(percent of GDP) developing countries 2.5 ible labor and product markets, and a general
2.0 opening up to international trade, may have
World
1.5 smoothed fluctuations and reduced inflation-
1.0 ary bottlenecks.25 Clearly, many of the above
Advanced economies
0.5 factors are not just reducing susceptibility to
0.0
1960 65 70 75 80 85 90 95 2000 05
22The role of monetary policy is emphasized in Clarida,
Terms-of-Trade Volatility 5 Emerging market and 25
Galí, and Gertler (2000); and Cecchetti, Flores-Lagunes,
(annual percent change) developing countries
20 and Krause (2006b). Importantly, globalization may
have strengthened policymakers’ incentives to maintain
15 low inflation, especially in developing economies—see
World
10 Box 3.1 in the April 2006 World Economic Outlook.
23See Fatás and Mihov (2003); and Chapter 2 in the
80
What Is Driving the Moderation of the Global Business Cycle?
Table 5.1. Cross-Sectional Regressions Table 5.2. Panel and Probit Regressions
Output Lost Length of Time in Probability of
Volatility Output Expansion Recessions Output Being in
Broad institutions –0.18* –0.02 0.19 –1.08* Volatility an Expansion
Financial development1 –1.99* –0.18* 0.39** –3.30** Broad institutions –0.07 –0.00
Monetary policy quality 0.07 –0.70 3.33* –18.27** Financial development1 0.22 –0.11
Fiscal policy volatility 0.58* 0.30** –0.72 0.58 Monetary policy quality –2.39*** 0.22***
Current account deficit 0.39 –0.03 –1.49*** 12.24*** Fiscal policy volatility 0.61* –0.04**
R2 0.49 0.50 0.49 0.65 Current account deficit –0.17 0.01
Trade openness –0.61 0.11***
Source: IMF staff calculations. Terms-of-trade volatility 0.05 –0.00
Note: number of countries = 78. Sample covers the period 1970–2005.
Statistically significant coefficients are in boldface; *, **, and *** denote R2 0.27 0.08
significance at the 10 percent, 5 percent, and 1 percent level, respectively.
Other controls include trade openness, terms-of-trade volatility, exchange Number of countries 78 78
rate flexibility, and share of agriculture in GDP. Number of observations 299 1,824
1To allow for nonlinearities, regressions employ both the level and the
Source: IMF staff calculations.
square of financial development; the joint coefficient presented represents Note: Results for “output volatility” are based on a panel fixed-
the marginal value, evaluated at the sample mean. effects regression, estimated using decade-average values over
1960–2005. Results for “probability of being in an expansion” are
based on a probit regression, estimated using annual data over
both demand and supply shocks but are also 1960–2005. Statistically significant coefficients are in boldface; *,
**, and *** denote significance at the 10 percent, 5 percent, and
raising trend productivity growth rates, which 1 percent level, respectively. Other controls include exchange rate
will also reduce the risk of an output decline. flexibility and share of agriculture in GDP.
1To allow for nonlinearities, regressions employ both the level
• Supply shocks, including in particular oil-supply
and the square of financial development; the joint coefficient
disruptions. These are widely understood to presented represents the marginal value, evaluated at the sample
have played an important role in driving pre- mean.
81
Chapter 5 The Changing Dynamics of the Global Business Cycle
82
What Is Driving the Moderation of the Global Business Cycle?
that this model-based frontier is downward Role of Structural Changes and Shocks
sloping—policymakers face a trade-off between The inward shift of the efficiency frontier
inflation volatility and output volatility. This since 1984 reflects a combination of changed
trade-off arises because when the economy structural characteristics of the economy
is hit by, for instance, an oil-price shock, and smaller shocks. To illustrate this, the
the Federal Reserve must decide whether figure shows two alternative frontiers for the
to tighten monetary policy to keep inflation 1966–83 period that are generated by the model
within a narrow range while temporarily toler- under two different sets of assumptions. First,
ating a decline in output or to accept higher the pre-1984 estimates of structural parameters
inflation so as to achieve more stable output. of the economy are replaced with post-1984
Similarly, the efficiency frontier EF2 represents estimates. Clearly, changes in the structural char-
the best possible combinations of inflation acteristics of the economy can account for only
and output volatility that could have been a small part of the estimated inward shift of the
achieved by the Federal Reserve during 1984– efficiency frontier. Second, the pre-1984 model
2006. It has shifted inward considerably relative is modified using post-1984 values for both struc-
to EF1 (mostly reflecting smaller shocks, as tural parameters and the distributions of supply
discussed below). shocks (e.g., productivity shocks and oil price
Crucially, the model suggests that there is a hikes). Unsurprisingly, the frontier EF1 shifts
significant difference between actual perfor- mainly downward because, in the short run,
mance at point A and what could have been supply shocks have a stronger effect on inflation
achieved during 1966–83, as represented by than on output. The difference between this
the set of points along EF1. This indicates that frontier and the post-1984 frontier EF2 repre-
suboptimal monetary policy played a major sents the contribution of demand shocks (for
role during that period in increasing both instance, smaller shocks to private consumption
inflation and output volatility. In contrast, over and investment demand, and/or greater stabil-
1984–2006, U.S. monetary policy became much ity in the conduct of fiscal policy). The role of
more credible, adjusting the policy rate more demand factors in explaining reduced output
aggressively in response to underlying inflation- volatility since 1984 is much larger than the role
ary pressures. This achieved outcomes closer to of supply shocks. This finding is consistent with
the efficiency frontier. the traditional interpretation of business cycles
The figure examines the role of monetary as being mostly demand driven.
policy and other factors in reducing output
and inflation volatility. The contribution of Conclusions
monetary policy to better performance of the Monetary policy has clearly improved the
U.S. economy is calculated as (AB – CD)/AB, economy’s performance by keeping it closer
where AB represents the total decline in volatil- to the efficiency frontier, and this gain is
ity between 1966–83 and 1984–2006 and CD not likely to disappear. What is less certain is
reflects the portion of this change unrelated whether the frontier itself will stay where it is,
to monetary policy. This calculation suggests that is, whether supply and demand shocks will
that around one-third of the reduction in continue to be small. As discussed in Chapter
output volatility was a result of better monetary 1, there are a number of important risks facing
policies. the global economy that could increase volatility
going forward.
For empirical evidence on the role of monetary
83
Chapter 5 The Changing Dynamics of the Global Business Cycle
Figure 5.10. Contribution to Outcome Differences difficult to detect in the panel regressions,
(Dependent variable and total difference in percentage points on the x-axis, because financial development tends to be a
and percent of total difference on the y-axis unless otherwise indicated) relatively slow-moving variable.
More stable monetary and fiscal policies in advanced economies than in emerging • The impact of the quality of monetary and
market and developing countries play a large part in explaining their lower volatility fiscal policy is sometimes difficult to disen-
and longer expansions. Much of the remaining difference reflects advanced
economies’ better institutional quality. Improvements in monetary policy and lower tangle. That said, in the cross section, better
terms-of-trade volatility account for much of the reduction in output volatility over monetary policy is associated with longer
time.
expansions, whereas volatility in fiscal policy is
Contributions of: Quality of institutions1 Financial development
Monetary policy Fiscal policy Current account deficit
associated with output volatility. Better mon-
Trade openness Terms-of-trade volatility Other variables2 etary and fiscal policies are both associated
Cross-Sectional Regressions: Total Difference—Advanced Versus in the panel with smaller output fluctuations.
Emerging Market and Developing Economies 150 Further, they are also associated with a higher
125 probability of being in an expansion.
100 • There is some evidence that large external defi-
75 cits can bring expansions to a premature end
50 (in the cross section), and that periods with
25 lower terms-of-trade volatility tend to have lower
0 output volatility (in the panel).
-25 The results imply that more stable monetary
-50 and fiscal policies in advanced economies play
Output volatility Lost output Length of Time in recessions
[–2.1] [–0.7] expansions [3 years] [–16.0] a large part in explaining lower volatility and
longer expansions in advanced economies, when
Panel and Probit Regressions: Total Difference—Advanced Versus
Emerging Market and Developing Economies 140 compared with emerging market and develop-
120 ing countries (Figure 5.10). Part of the remain-
100 ing difference reflects advanced economies’
80
better institutional quality. Their lower terms-
60
of-trade volatility also plays a role. In a similar
40
vein, better monetary policy, more stable fiscal
20
0
policy, and greater trade openness in advanced
-20 economies all help to increase their probability
-40 of being and remaining in an expansion, relative
Output volatility [–1.8] Probability of expansions [16.8] 3
to emerging market and developing countries
Panel Regressions: Total Difference—1970s Versus 2000s 120 (see Figure 5.10).
100 The results can also be applied to explain the
80 large reduction in average volatility between
60
the 1970s and the current decade, both for the
world as a whole and for advanced and devel-
40
oping economies separately. Improvements in
20
monetary policy account for much of the reduc-
0 tion in volatility over time (see Figure 5.10). A
-20 significant portion of the remainder reflects
World output Advanced economies Developing economies
volatility [1.4] output volatility [1.5] output volatility [1.7] improved fiscal policy (in advanced econo-
Sources: Beck, Demirgüç-Kunt, and Levine (2007); Heston, Summers, and Aten (2006);
mies), and trade liberalization and institutional
Maddison (2007); Marshall, Jaggers, and Gurr (2004); Reinhart and Rogoff (2004); improvements (in emerging market and devel-
Wacziarg and Welch (2003); World Bank, World Development Indicators database (2007);
and IMF staff calculations (see Appendix 5.1 for details). oping countries). Lower terms-of-trade volatility
1Initial values for the cross-sectional and panel regressions.
2See Tables 5.1 and 5.2 for the list of “other variables.” than observed in the 1970s does have an impor-
3The y-axis indicates the probability of an expansion in percentage points. tant, but certainly not a dominant, role to play.
84
Appendix 5.1. Data and Methods
This is consistent with the finding, expressed volatility have played an important, but not
in Box 5.2, that policy mistakes were an impor- dominant, role.
tant contributor to the volatility observed in The prospects for future stability should
the 1970s.28 nevertheless not be overstated. The process of
globalization continues to present policymakers
with new challenges, as reflected in the difficul-
Conclusions ties in managing volatile capital flows, increas-
The current global expansion certainly stands ing exposure of investors to developments in
out in comparison with the experience of the overseas financial markets, and the uncertainties
past three decades, but it is not unprecedented. associated with large global current account
In recent years, output growth has been much imbalances. The recent return of interest rates
more rapid than observed at any time since to more neutral levels in most major advanced
the oil shocks of the 1970s. Compared with economies, the corrections of asset prices in
the 1960s, however, neither the strength nor some countries, and the current rise in risk
the length of the current expansion appears premiums and tightening of credit market
exceptional. That said, rapid growth has been conditions may also test the strength of the cur-
shared across countries more broadly than in rent expansion. Overconfidence in the ability of
the past, and output volatility in most countries the current policy framework to deliver stability
and regions has been significantly lower than indefinitely would certainly not be warranted.
during the 1960s. Although the business cycle has changed for the
Advanced economies in particular have better, policymakers must remember that it has
improved their performance since the 1970s, not disappeared.
and they have typically experienced long
expansions. Output stabilization in emerging
market and developing countries has been Appendix 5.1. Data and Methods
more gradual and modest, with certain regions The main authors of this appendix are Martin
experiencing deep and sometimes recurrent Sommer and Nikola Spatafora, with support from
crises. Over time, greater trade and financial Angela Espiritu and Allen Stack. Massimiliano
integration have increased the covariance of Marcellino provided consultancy support.
growth across countries, and therefore at the
Expansions are defined as periods of non
world level output volatility is only slightly lower
negative growth of real GDP per capita.
than in the 1960s.
Analogously, recessions are defined as periods
This chapter finds that the increasing stability
of negative growth. Most of the analysis in this
of economies and the associated increase in the
chapter therefore adopts the concept of “classi-
durability of expansions largely reflect sources
cal” business cycles as discussed in, for example,
that are likely to prove persistent. In particular,
Artis, Marcellino, and Proietti (2004) and Hard-
improvements in the conduct of monetary and
ing and Pagan (2001).29 Expansions are identi-
fiscal policy, as well as in broader institutional
quality, are all robustly associated with smaller
fluctuations in output, both over time and 29Harding and Pagan (2001) review various alterna-
across countries. Reductions in terms-of-trade tive business cycle definitions and their implications for
business cycle properties. Business cycle research on
advanced economies has typically used headline GDP
28Caution is needed in interpreting these results as series to determine the timing of expansions and reces-
indicating a small role for “good luck” in recent years. The sions. This chapter, however, also analyzes many emerging
panel regressions involve relatively large error terms, which market and developing countries with high population
may partly reflect temporary shocks. That said, the esti- growth rates. To ease cross-country comparisons, the
mated equations do a very good job in matching the aver- chapter therefore defines business cycles using per capita
age business cycle characteristics for broad country groups. output growth.
85
Chapter 5 The Changing Dynamics of the Global Business Cycle
fied using annual data and in per capita terms analysis of volatility over the past decade (in
to allow for broad comparisons across countries advanced economies, the length of the typical
and over time. Expansions based on quarterly cycle increased to about 10 years during the
data would likely be shorter for many countries. 1980s and 1990s).
For the United States, the identified recessions The change in output volatility from period B to
broadly match those reported by the National period A is decomposed as follows:
Bureau of Economic Research, with the excep- n
tion of the 1960 recession, which cannot be var Ayt – var Byt = ∑ {var A(Contt,i) – var B(Contt,i)}
i=1
n
identified from annual data. + ∑ {stdA(Contt,i)stdA(Contt,j)
i=1,j =1
and t≠j
86
Appendix 5.1. Data and Methods
which the five-year moving average of real GDP cial Development and Structure database
growth (1) exceeds 5 percent, and (2) remains (2007).31 To allow for nonlinearities, regres-
above 5 percent for at least two years. Subse- sions employ both the level and the square of
quently, the beginning of the takeoff is identi- this variable; the joint coefficient presented
fied within the five-year window before this year. represents the marginal value, evaluated at
the sample mean.
• Quality of monetary policy: the index is defined
Econometric Analysis as exp[–0.005 * (inflation – 2 percent)2]. This
The econometric analysis (Tables 5.1 and 5.2) measure of price stability rapidly deteriorates
considers the following dependent variables: once inflation rises above 10 percent. For
• output volatility: defined as the standard devia- instance, the index equals 1 when inflation
tion of detrended GDP growth per capita. equals 2 percent, roughly ¾ when inflation
Detrending is carried out using the Hodrick- equals 10 percent, and 0.2 when inflation
Prescott (HP) filter; equals 20 percent. The index moves only
• share of output that is lost to recessions and slow- slightly in response to short-term inflation
downs: defined as the cumulative sum of all fluctuations, such as those stemming from oil
below-trend outputs, divided by the cumula- price changes, so long as the initial inflation
tive sum of all outputs. Detrending is again level is low. Although this variable is clearly
carried out using the HP filter; and influenced by factors other than the quality of
• average length of expansions; share of time spent monetary policy, it is nevertheless correlated
in recessions; whether a country is in an expansion with other proxies for the quality of the insti-
in any given year: expansions and recessions tutional setup behind monetary policy, over
are defined as described at the start of this the more limited sample for which the latter
appendix. are available.32
Explanatory variables employed in the analysis • Volatility of fiscal policy: measured as the roll-
include the following: ing 10-year standard deviation of cyclically
• Broad institutions: measured using the “execu- adjusted government expenditure to GDP,
tive constraint” variable from Marshall, Jag- following the country-specific, instrumental-
gers, and Gurr’s Polity IV data set (2004).30 variable estimation procedure set out in Fatás
This variable is instrumented using country- and Mihov (2003).33 The government expen-
and period-specific initial values. The variable diture data are from the World Bank’s World
follows a seven-category scale, with higher
values denoting better checks and balances in
place on the executive branch of the gov- 31For more details on the Financial Development and
ernment. A score of one indicates that the Structure database, see www.worldbank.org.
32For instance, a cross-sectional regression of the
executive branch has unlimited authority in monetary policy index on a measure of the turnover of
decision making; a score of seven represents central bank governors yields a t-statistic of 5.5 and an
the highest possible degree of accountability R 2 of 0.24. The analogous fixed-effects panel regression
yields a t-statistic of 4.0 and an R 2 of 0.10.
to another group of at least equal power, such 33Using government expenditures, rather than the
as a legislature. government balance, minimizes endogeneity concerns
• Financial development: measured using the ratio that stem from difficulties in cyclical adjustment. As dis-
cussed in Fatás and Mihov (2003, p. 11), “There are both
of private sector credit by banks and other
theoretical considerations and empirical estimates that
financial institutions to GDP. Data are from support the idea that spending (excluding transfers) does
Beck, Demirgüç-Kunt, and Levine’s Finan- not react contemporaneously to the cycle. On the other
hand, there is plenty of evidence that the budget deficit
is automatically affected by changes in macroeconomic
30For more details on the Polity IV database, see www. conditions and therefore more subject to endogeneity
cidcm.umd.edu/polity. problems.”
87
Chapter 5 The Changing Dynamics of the Global Business Cycle
Development Indicators database (2007)34 are estimated using annual data, starting in
when available and the IMF’s World Eco- 1960.
nomic Outlook database otherwise. Figure 5.10 is constructed as follows. First,
• Large current account deficit: this indicator each regression is estimated using the whole
equals 1 when the current account deficit sample. Then the sample is split into advanced
exceeds 5 percent of GDP; the indicator economies versus emerging market and develop-
equals zero otherwise. Data are from the IMF’s ing countries, and mean values of the dependent
World Economic Outlook database when avail- and explanatory variables are calculated for each
able and the World Bank’s World Develop- subsample. For each explanatory variable, the
ment Indicators database (2007) otherwise. difference in its mean value across subsamples is
• Trade openness: the Wacziarg and Welch (2003) multiplied by the relevant coefficient (estimated
index is based on average tariff rates, average using the whole sample). This yields the contri-
nontariff barriers, the average parallel market bution of the relevant explanatory variable to
premium for foreign exchange, the presence the (mean) difference of the dependent vari-
of export marketing boards, and the presence able between advanced and other economies.
of a socialist economic system. The variable Finally, and analogously, the above procedure
is equal to zero prior to liberalization and is repeated, but with the sample split by decade
1 from the beginning of liberalization.35 (rather than into advanced versus other econo-
• Exchange rate flexibility: measured based on mies). This yields the contribution of each
the Reinhart-Rogoff coarse index of de facto explanatory variable to the (mean) difference of
exchange rate flexibility, collapsed to a three- the dependent variable between decades.
value indicator (where 1 denotes a fixed or
pegged exchange rate regime, 2 denotes an Other Data Sources
intermediate regime, and 3 denotes a free • Real GDP and its components. Data on an aggre-
float). The Reinhart-Rogoff classification takes gate and per capita basis are from (1) Heston,
into account the existence in some economies Summers, and Aten’s Penn World Tables Ver-
of dual rates or parallel markets, and it uses sion 6.2 (2006);38 (2) the World Bank’s World
the volatility of market-determined exchange Development Indicators database (2007); (3)
rates to statistically classify an exchange rate the IMF’s World Economic Outlook database;
regime.36 and (4) Maddison (2007).39 Data from these
• Share of agriculture in GDP: the data are from sources are spliced multiplicatively together
the World Bank’s, World Development Indica- in the order in which they are numbered
tors database (2007). to produce the longest time series possible.
All cross-sectional regressions are estimated Most of the data, however, are from the Penn
using average values over the period 1970– World Tables, with data for 2007 based on
2003.37 Panel regressions are estimated using all projections from the IMF’s World Economic
available decade-average observations, starting Outlook database. Data from Maddison are
in 1960, and use fixed effects. Probit regressions available only for total GDP and GDP per
capita.40 Given the ongoing discussion about
the accuracy of pre–World War II data (see
34For more details on the World Development Indica- Box 5.3), the analysis of pre-war data is con-
tors data, see www.worldbank.org.
35For more details on the openness variable, see www.
by estimating the regressions separately over the subperi- how GDP data vary across data sets, including across dif-
ods 1970–83 and 1984–2003. ferent versions of the Penn World Tables.
88
Appendix 5.1. Data and Methods
Box 5.3. New Business Cycle Indices for Latin America: A Historical Reconstruction
Important insights into the roots of business such dynamic factor models can be also
cycle volatility can be gained from long-run suitable for “backcasting” purposes, notably
data spanning a variety of policy regimes and in the reconstruction of aggregate indices
institutional settings. Yet there is a striking of economic activity. A critical requirement
dearth of systematic work along these lines is the availability of a broad set of variables
for most countries outside North America and that is both heterogeneous enough and com-
western Europe. prises individual series that bear a close rela-
A main obstacle to this line of research tion to aggregate cyclical behavior. Natural
has been limited or patently unreliable candidates include investment, government
historical GDP data for developing coun- revenues and expenditures, and sectoral
tries. Although the work of Maddison (1995, output, as well as external trade and a host
2003) has been useful in making long-run of financial variables for which there are data
data more easily accessible to macroecono- stretching far back in time. A main advantage
mists, important deficiencies remain in the of such a methodology is its relative robust-
pre–World War II data reported by Maddison. ness to errors in the measurement of individ-
For most developing countries, these data are ual variables—a problem deemed particularly
either provided only for sparse benchmark severe in developing country statistics.
years or compiled directly from secondary Provided that such measurement errors are
sources relying on a very limited set of macro- largely idiosyncratic, the resulting estimates
economic variables and often using disparate will be far less sensitive to the effects of such
methodologies to build up GDP estimates. errors than the usual procedure of adding up
As discussed below, this procedure can be sectoral output indices to estimate an aggre-
misleading. gate GDP, where each of these individual
This box summarizes a new methodol- indices is measured with substantial idiosyn-
ogy for real GDP reconstruction laid out in cratic error.
Aiolfi, Catão, and Timmerman (2006; ACT The ACT backcasting methodology con-
henceforth), and compares the estimates sists of three steps. First, all individual
for four Latin American countries (Argen- series are made stationary by detrending—a
tina, Brazil, Chile, and Mexico) with those standard procedure in factor model estima-
reported by Maddison (2007). Underpinning tion. Second, common factors are extracted
this new methodology is the idea that a cross from the cross section of stationary series.
section of economic variables shares a com- The third step consists of projecting the
mon factor structure. That is, fluctuations in extracted factors on real GDP by an ordi-
any individual economic variables (such as nary least squares regression confined to the
industrial production, investment, and so period for which real GDP data are judged
on) stem from the combination of a common to be sufficiently reliable (usually sometime
factor that affects all individual economic after World War II). Although the resulting
variables in an economy (that is, “a tide indices track actual GDP very closely over this
that raises all boats”) plus an idiosyncratic latter “in-sample” period (yielding very high
(that is, sector- or variable-specific) compo- R 2s and t-ratios), the methodology’s reliance
nent. Recent time-series techniques allow a on coefficient stability over a period span-
sounder formalization of this classical factor ning several decades could potentially be
approach, and recent studies have used it criticized. However, Stock and Watson (2002)
for forecasting purposes. ACT argue that show that such common factor estimates are
consistent even under temporal instability
in the individual time series, provided this
Note: The main author of this box is Luis Catão. instability averages out in the construction
89
Chapter 5 The Changing Dynamics of the Global Business Cycle
therein.
90
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• Working-age population. Interpolated five- Bulgaria, Czech Republic, Hungary,
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Chapter 5 The Changing Dynamics of the Global Business Cycle
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