Working paper No. 58
By Allison Holland and Andrew Scott
This paper considers the causes of post-war UK business cycles. Using an extended stochastic growth model we construct estimates of productivity and preference shocks both of which are highly persistent, volatile and potentially capable of explaining UK business cycles. We find the productivity term is the dominant explanation of UK output fluctuations but our estimated preference shift is crucial in understanding employment movements. We use a variety of Granger causality tests to establish whether these productivity and preference terms are predictable and so can be potentially considered as the cause of UK business cycles or whether they are themselves Granger caused by other variables. We find our estimated productivity term is not predicted by any demand-side variable, including various fiscal and monetary policy instruments, but is to a limited extent by oil prices and the share of taxes in GDP. This suggests that our ‘productivity’ shock may also reflect other supply-side influences. In contrast we find our ‘preference’ shift is predicted to a substantial extent by real variables, such as the terms of trade and oil prices, and nominal variables, such as the money supply and the price level. The implications of these findings for competing theories of the business cycle and for the monetary transmission mechanism are discussed.