The transformation of macroeconomic policy and research prize Lecture, December 8, 2004 by

profession has learned so much. No longer do economists conjecture and

speculate. Instead they make quantitative statements as to the consequences

of various shocks and features of reality for business cycle fluctuations. This

paper began a constructive and fruitful research program.

3.1 Business cycle facts

In the 1970s after the development of dynamic economic theory, it was clear

that something other than the system-of-equations approach was needed if

macroeconomics was to be integrated with the rest of economics. I want to

emphasize that macroeconomics then meant business cycle fluctuations.

Growth theory, even though it dealt with the same set of aggregate economic

variables, was part of what was then called microeconomics, as was the study

of tax policies in public finance.

Business cycles are fluctuations in output and employment about trend.

But what is trend? Having been trained as a statistician, I naturally looked to

theory to provide the definition of trend, with the plan to then use the tools

of statistics to estimate or measure it. But theory provided no definition of

trend, so in 1978 Bob Hodrick and I took the then-radical step of using an

operational definition of trend.

1

With an operational definition, the concept

is defined by the procedure used to determine the value of the concept.

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1 

A shortened version of this 1978 Carnegie Mellon working paper, a copy of which I do not have,

is a 1980 Northwestern University working paper. At the time, this paper was largely ignored 

because the profession was not using the neoclassical growth model to think about business cycle

fluctuations. But once the then-young people in the profession started using the neoclassical

growth model to think about business cycles, the profession found the statistics reported in this

paper of interest.

Figure 1. Deviations from Trend of U.S. GDP and Hours.

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2 

See Stigler’s (1978) history of statistics.

Our trend is just a well-defined statistic, where a statistic is a real valued

function. Hodrick and Prescott’s (1980) trend statistic mimics well the

smooth curve that economists fit through the data. The family of trends we

considered is one-dimensional. The one in the family that we used is the first

one we considered. Later we learned that the actuaries use this family of

smoothers, as did John von Neumann when he worked on ballistic problems

for the U.S. government during World War II.

2

A desirable feature of this 

definition is that with the selection of smoothing parameters for quarterly 

time series, there are no degrees of freedom and the business cycle statistics

are not a matter of judgment. Having everyone looking at the same set of 

statistics facilitated the development of business cycle theory by making 

studies comparable.

One set of key business cycle facts are that two-thirds of business cycle 

fluctuations are accounted for by variations in the labor input, one-third by

variations in total factor productivity, and virtually zero by variations in the 

capital service input. The importance of variation in the labor input can be

seen in Figure 1.

This is in sharp contrast to the secular behavior of the labor input and output,

which is shown in Figure 2. Secularly, per capita output has a strong upward

trend, while the per capita labor input shows no trend.

A second business cycle fact is that consumption moves procyclically; that

is, the cyclical component of consumption moves up and down with the 

cyclical component of output. A third fact is that in percentage terms, invest-

Figure 2. Indices of Per Capita Real GDP and Hours.

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ment varies 10 times as much as does consumption. Consequently, invest-

ment variation is a disproportionate part of cyclical output variation. This is

shown in Figure 3.

3.2 Inference drawn from these facts

Now why did economists looking at these facts conclude that they ruled out

total factor productivity and other real shocks as being a significant contributor

to business cycle fluctuations? Their reasoning is as follows. Leisure and 

consumption are normal goods. The evidence at that time was that the real

wage was acyclical, which implies no cyclical substitution effects and leaves

only the wealth effect. Therefore, in the boom when income is high, the

quantity of leisure should be high, when in fact it is low. This logic is based on

partial equilibrium reasoning, and the conclusion turned out to be wrong.

In the 1970s a number of interesting conjectures arose as to why the 

economy fluctuated as it does. Most were related to finding a propagation 

mechanism that resulted in Lucas’s monetary surprise shocks having 

persistent real effects. With this theory, leisure moves countercyclically in con-

formity with observations. The deviations of output and employment from

trend are not persistent with this theory, but in fact they are persistent. This

initiated a search for some feature of reality that when introduced gives rise

to persistent real effects. To put it another way, economists searched for what

Frisch called a propagation mechanism for the effects of monetary surprises.

Taylor (1980) and Fischer (1977) provided empirical and theoretical evidence

in support of their conjecture that staggered nominal wage contracting might

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Figure 3. Deviations from Trend of U.S. Consumption and Investment.

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