The shape of business cycles: a cross-country analysis of Friedman's plucking theory

Summary

Focus 

As the advanced economies continue to recover from the Covid-19 recession, it would be helpful to know more about how economies typically behave following recessions. While large recessions tend to precede strong expansions, strong expansions do not tend to precede large recessions. Are economic recoveries complete? If not, what factors influence how far a recovery will run?

Contribution 

Our paper presents new evidence on the shape of business cycles in advanced economies. We compare real-life patterns with the predictions of Milton Friedman's "plucking theory" of the business cycle, which implies that, like a guitar string, the harder an economy is "plucked down", the stronger it should come back up. Previous evidence for the plucking theory is considerably stronger for the United States than it is for a broader set of advanced economies. We present new evidence based on a sample of 12 advanced economies and more than 50 recessions.

Findings 

We find that in countries where labour markets are flexible (Australia, Canada, the United Kingdom and the United States), unemployment rates typically return to pre-recession levels, in line with Friedman's theory. Elsewhere, unemployment rates are less cyclical. Output recoveries differ less across countries, but more across episodes: on average, half of the decline in GDP during a recession persists in the recovery. Our results suggest that policymakers should aim to restore full employment quickly after a recession, while taking care to ensure that their actions do not overstimulate the construction sector, where excesses are costly and workers find it difficult to transfer their skills to alternative sectors.

Abstract

We test the international applicability of Friedman's famous plucking theory of the business cycle in 12 advanced economies between 1970 and 2021. We find that in countries where labour markets are flexible (Australia, Canada, United Kingdom and United States), unemployment rates typically return to pre-recession levels, in line with Friedman's theory. Elsewhere, unemployment rates are less cyclical. Output recoveries differ less across countries, but more across episodes: on average, half of the decline in GDP during a recession persists. In terms of sectors, declines in manufacturing are typically fully reversed. In contrast, construction-driven recessions, which are often associated with bursting property price bubbles, tend to be persistent.

JEL Classification: E24; E32

Keywords: business cycle; growth; labour market; unemployment