Estimating Length of Business Cycles

Jeremey Ponrajah
Professor: Claustre Bajona

Macro project
EF8902(Fall/2015)

The term business cycles refers to the fluctuations in the rate of economic
activity, usually measured through levels of employment, prices and production. On the other hand, real business-cycles refers to when the fluctuations
are accounted for by real shocks instead of nominal shocks. Estimating the
length of theses cycles are of interest to not only single individuals but to
government organizations. For example, the severity of a recession is usually
described by the duration and not for instance by the number of unemployed
categorized by income bracket. Furthermore, the change in the length of the
business cycle from one period to another can give us a rudimentary idea of
if the economy is becoming more stable or less stable. The stability of the
economy can be credited to for example the knowledge policy makers gained
from the Great Depression. That is policy makers realized that contracting the money supply during a recession will led to higher unemployment.
Thus, it is reasonable to assume that the length of the real business should
hit some stable number and a recession like the Great Depression is out of
the ordinary because policy makers have learned from their mistakes.
Fortunately, the National Bureau of Economic Research (NBER) announces and records: the length of business cycles, how far they are apart
and other information. Their definition of a recession is as follows a recession is a significant decline in economic activity spread across the economy,
lasting more than a few months, normally visible in real GDP, real income,
employment, industrial production, and wholesale-retail sales1 .
1

http://www.nber.org/cycles.html

Figure 1: US Business Cycle Expansions and Contractions

For this specific application we are interested in the average length of the
business cycle from 1945-2009, which is about 11 quarters long according to
the table above. We will use this statistic to compare against our estimation
of the length of the stochastic business cycle.
What we are interested in doing today is to show the existence of stochastic business cycles in the quarterly growth rate of the U.S. real GNP per
capita. This can be accomplished by factoring the difference equation of
the auto regression obtained from lagging the quarterly growth rate of the
U.S. real GNP per capita on itself. We will use the simple transformation
of taking the log difference to obtain the growth rate.
yt = ln(GN Pt ) ln(GN Pt1 )

(1)

For simplicity we will use a auto regression(AR) of the third order. If

the second-order difference equation of the model can be factored as (1
w1 B)(1 w2 B), then the AR(3) can be regarded as three AR(1) on top of
each other. However, if the roots of the second order difference equation of
the AR(3) are complex (complex conjugate pair), then average length of the
stochastic cycles is given by:
2

k=
(2)
1
cos [1 /(2 2 )]
3


If the complex solution can be written as a bi, where i = 1, then we
have 1 = 2a, 2 = (a2 + b2 ). In business and economic applications,
complex characteristic roots are important. They give rise to the behaviour
of business cycles. The graph of ACF should show a picture of damping sine
and cosine waves. Also, the graph of ACF can provide visual confirmation
of a stochastic cycle.
Autocorrelation function(ACF):
Cov(yt , ytL )

Cov(yt , ytL )
L = p
=
=
V ar(yt )
V ar(yt )V ar(ytL )

PT

t=L (yt y)(ytL

PT
2
t=1 (yt y)

y)

where 0 L < (T 1)

Figure 2: ACF of the real GNP per capita (growth rate)

Data: Real gross national product per capita, Chained 2009 Dollars, Quarterly, Seasonally Adjusted, 1945:I-2015:III
Let us run the autoregression on the growth rate.
yt = 0.0049 + 0.3354yt1 + 0.1323yt2 0.1127yt3 + t ,  = 7.9e05
Rewrite the equation:
4

yt 0.3354yt1 0.1323yt2 + 0.1127yt3 = 0.0049 + t

We obtain a corresponding third-order difference equation:
0.1127B 3 0.1323B 2 0.3354B + 1
Real solution:
B = 2.1441
Complex solution:
B = 1.6590 + 1.1773i
B = 1.6590 1.773i
The second order factor of the AR(3) model confirms the existence of stochastic business cycles in the quarterly growth rate of the real U.S. GNP.
k=

2
2

=
= 9.1954
2
2
0.6833
1.659 + 1.773 )

cos1 (1.659/

The average business cycle is approximately 9 quarters or a little over

two years in length according to our calculations. The original reference material, for the second quarter of 1947 to the first quarter of 1991 calculated
a business cycle of 10.83 quarters2 . Furthermore, according to the NBER
for the period 1945-2009 the average business cycle was 11.1 quarters long.
Therefore, we can predict that the business cycle we are currently in should
last about 2 years. In addition, the two recessions that occurred in 2001
and 2009 did not increase or decrease the length by much according to the
calculations. This confirms our prediction that business cycles are becoming
stable and periodic.
In conclusion, the change in the average business cycle length has not
changed considerably. It is in the range of about 9-11 quarters in length for
both the information provide by NBER and the calculations we conducted
from the autoregression. It should be noted also that our procedure is quantitate complement to the information provide by the NBER.

Tsay, Ruey S. Analysis of financial time series. Vol. 543. John Wiley & Sons, 2005.