Chari,Kehoe and McGrattan(2005)(CKM)argue that a procedure they call Business Cycle Accounting (BCA) is useful for identifying promising directions for model development. The key substantive finding of CKM is that financial frictions like those analyzed by Carlstrom andFuerst (1997) (CF) and Bernanke, Gertlerand Gilchrist (1999) (BGG) are not promising avenues for studying business cycles. Based on our analysis of business cycle data for the US inthe 1930 sandforthe US and 14 other OECD countries in the postwar period, we find that the CKM conclusion is not warranted.
The BCA strategy begins with the standard real business cycle (RBC) model, augmented by introducing four shocks, or 'wedges'. Ave ctorautoregressive representation (VAR) for thew edges is estimated using macroeconomic data on output, consumption, investment and government consumption. The macroeconomic data are assumed to be observed witha small measurement error whose variance is fixedapriori. The fitted wedges have the property that when they are fed simultaneously to the augmented RBC model, the model reproduces the four macroeconomic data series up to the small measurement error. The importance of a particular wedge is determined by feeding it to the model, holding all the other wedges constant, and comparing the resulting model predictions with the data.
One of the wedges, thein tertemporal wedge, is the shock that enters between the intertemporal marginal rate of substitution in consumption and the rate of return on capital. CKM argue that this wedge contributes very little to business cycle fluctuations, for the following two reasons: (i) the wedge accounts for only a small part of the move men tin macroeconomic variables during recessions and (ii) the wedge drives consumption and investment in opposite directions, while these two variables display substantial positivecomove men toverthebusiness cycle. CKM assertthat their conclusions are robust to various model perturbations, including the introduction of adjustment costs in investment.
