A Unified Approach for Jointly Estimating the Business and Financial Cycle, and the Role of Financial Factors

Abstract

We jointly estimate the U.S. business and financial cycle through a unified empirical approach while simultaneously accounting for the role of financial factors. Our approach uses the Beveridge-Nelson decomposition within a medium-scale Bayesian Vector Autoregression. First, we show, both in reduced form and when we identify a structural financial shock, that variation in financial factors had a larger role post-2000 and a more modest role pre-2000. Our results suggest that the financial sector did play a role in overheating the business cycle pre-Great Recession. Second, while we document a positive unconditional correlation between the credit cycle and the output gap, the correlation of the lagged credit cycle and the contemporaneous output gap turns negative when we condition on a financial shock. The sign-switch suggests that the nature of the underlying shocks may be important for understanding the relationship between the business and financial cycles.