Federal Reserve Bank of Minneapolis Research Department Business Cycle Accounting

We propose a simple method for guiding researchers in developing quantitative models of economic fluctuations. We show that a large class of models, including models with various frictions, are equivalent to a prototype growth model with time varying wedges that, at least at face value, look like time-varying productivity, labor taxes, and capital income taxes. We label the time varying wedges efficiency wedges, labor wedges, and investment wedges. We use data to measure them and then feed the measured back into the prototype growth model. We assess the fraction of fluctuations in output, employment and investment accounted for by these wedges during the Great Depression and the business cycle of the early 1980s. For the Great Depression we find that the efficiency and labor wedges in combination account for essentially all of the fluctuations and investment wedges play no role. For the business cycle of the early 1980s we find that the efficiency wedge plays a more important role and the labor and investment wedges play minor roles. We show that our results are not sensitive to alternative measures of capital utilization. ∗Chari, University of Minnesota and Federal Reserve Bank of Minneapolis; Kehoe, Federal Reserve Bank of Minneapolis and University of Minnesota; McGrattan, Federal Reserve Bank of Minneapolis and University of Minnesota. The authors thank the National Science Foundation for support. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. We propose a simple method for guiding researchers in developing quantitative models of economic fluctuations. Our method has two components: an equivalence result and an accounting procedure. The equivalence result is that a large class of models, including models with various frictions, are equivalent to a prototype growth model with time varying wedges that, at least at face value, look like time-varying productivity, labor taxes, and capital income taxes. For example, we show that an economy in which the technology is constant but input financing frictions vary over time is equivalent to a growth model with time-varying productivity. We show that models with sticky wages and monetary shocks or unions and antitrust policy shocks are equivalent to a growth model with time-varying labor taxes, and a model with investment financing frictions and wealth redistribution shocks is equivalent to a growth model with time-varying capital income taxes. These examples lead us to label the time varying wedges as efficiency wedges, labor wedges, and investment wedges. Our accounting procedure begins by using the data together with the equilibrium conditions of a prototype growth model to measure the wedges. We then feed the values of these wedges back into the growth model one at a time and in combinations to assess what fraction of the output movements can be attributed to each wedge separately and in combination. By construction, all three wedges account for all of the observed movements in output. In this sense, our method is an accounting procedure. We apply our method to the Great Depression of the 1930s and to the 1982 recession in the United States. In the Great Depression, output, employment and investment declined dramatically in the early 1930’s. The ensuing recovery was slow so that even by 1939, output was well below trend. The slowness of the recovery was especially marked for employment which in 1939 was still at its 1933 level. Our accounting shows that the efficiency wedge alone accounts for roughly two-thirds of the decline in output and about half the decine in employment from 1929 to 1933 but this wedge cannot account for the sluggish recovery in either output or employment. The labor wedge alone accounts for much of the fall in employment but can only account for a third of the fall in output from 1929 to 1933. In terms of the recovery, the labor wedge accounts for all the sluggishness in employment and much of the failure of output to return to trend. In combination, the efficiency and labor wedges account for all of the fall in output, employment and investment from 1929 to 1933 and and the behavior of these variables in the recovery. The investment wedge improves during much of the 1930s, in the sense that investment decisions become less distorted. This wedge cannot account for either the Depression or the slow recovery. For the 1982 recession of the United States we find that the efficiency wedge alone accounts for most of the decline and recovery in output, but misses some of the downturn in labor. The labor wedge alone produces hardly any fluctuations in output but captures some of the downturn in labor. Together they capture the downturn in output well, though they produce a sharper recovery than in the data. The investment wedge steadily worsens throughout the recession as well as the recovery. Relative to the great depression we find that the labor wedge plays a much smaller role, and the worsening of the investment wedge helps account for the modest nature of the recovery. Overall, however, as in the great depression we find that there is little room for investment wedges to play much of a role. The goal of this business cycle accounting is to guide researchers in developing detailed models with the kinds of frictions that can deliver the quantitatively relevant types of observed wedges in the prototype economy. For example, both the sticky wage and cartelization theories are promising explanations of the observed labor wedges, while the simplest models of investment financing frictions are not. Theorists attempting to develop models of particular channels through which shocks cause large fluctuations in output will benefit from asking whether those channels are consistent with the fluctuations in wedges that we document. We emphasize that we view our method as a useful first step in guiding the construction of detailed models. In building detailed models, theorists face hard choices on where to introduce frictions in markets. Our method is intended to help in making those choices.