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Thursday, January 19, 2006

New Support for Friedman's Plucking Model

Milton Friedman's "plucking model" is an interesting alternative to the natural rate of output view of the world. The typical view of business cycles is one where the economy varies around a trend value (the trend can vary over time also). Milton Friedman has a different story. In Friedman's model, output moves along a ceiling value, the full employment value, and is occasionally plucked downward through a negative demand shock. Quoting from the article below:

In 1964, Milton Friedman first suggested his “plucking model” (reprinted in 1969; revisited in 1993) as an asymmetric alternative to the self-generating, symmetric cyclical process often used to explain contractions and subsequent revivals. Friedman describes the plucking model of output as a string attached to a tilted, irregular board. When the string follows along the board it is at the ceiling of maximum feasible output, but the string is occasionally plucked down by a cyclical contraction.

Friedman found evidence for the Plucking Model of aggregate fluctuations in a 1993 paper in Economic Inquiry. One reason I've always liked this paper is that Friedman first wrote it in 1964. He then waited for almost twenty years for new data to arrive and retested his model using only the new data. In macroeconomics, we often encounter a problem in testing theoretical models. We know what the data look like and what facts need to be explained by our models. Is it sensible to build a model to fit the data and then use that data to test it to see if it fits? Of course the model will fit the data, it was built to do so. Friedman avoided that problem since he had no way of knowing if the next twenty years of data would fit the model or not. It did. I was at an SF Fed Conference when he gave the 1993 paper and it was a fun and convincing presentation. Here's a recent paper on this topic that supports the plucking framework (thanks Paul):

Asymmetry in the Business Cycle: New Support for Friedman's Plucking Model, Tara M. Sinclair, George Washington University, December 16, 2005, SSRN: Abstract This paper presents an asymmetric correlated unobserved components model of US GDP. The asymmetry is captured using a version of Friedman's plucking model that suggests that output may be occasionally "plucked" away from a ceiling of maximum feasible output by temporary asymmetric shocks. The estimates suggest that US GDP can be usefully decomposed into a permanent component, a symmetric transitory component, and an additional occasional asymmetric transitory shock. The innovations to the permanent component and the symmetric transitory component are found to be significantly negatively correlated, but the occasional asymmetric transitory shock appears to be uncorrelated with the permanent and symmetric transitory innovations. These results are robust to including a structural break to capture the productivity slowdown of 1973 and to changes in the time frame under analysis. The results suggest that both permanent movements and occasional exogenous asymmetric transitory shocks are important for explaining post-war recessions in the US.

Let me try, within my limited artistic ability, to illustrate further. If you haven't seen a plucking model, here's a graph to illustrate (see Piger and Morley and Kim and Nelson for evidence supporting the plucking model and figures illustrating the plucking and natural rate characterizations of the data). The "plucks" are the deviations of the red line from blue line representing the ceiling/trend:

Notice that the size of the downturn from the ceiling from  ab (due to the "pluck") is predictive of the size of the upturn from bc that follows taking account of the slope of the trend. I didn't show it, but in this model the size of the boom, the movement from bc, does not predict the size of the subsequent contraction. This is the evidence that Friedman originally used to support the plucking model. In a natural rate model, there is no reason to expect such a correlation. Here's an example natural rate model:

Here, the size of the downturn ab does not predict the size of the subsequent boom bc. Friedman found the size of ab predicts bc supporting the plucking model over the natural rate model.

    Posted by on Thursday, January 19, 2006 at 12:18 AM in Academic Papers, Economics, Macroeconomics | Permalink  TrackBack (0)  Comments (9)

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