In Discussion Paper No. 1409, Allison Holland and Research Affiliate Andrew Scott consider the main causes of post-war UK business cycles. Using an extended stochastic growth model, estimates of productivity and preference shocks are constructed. Both shocks are found to be highly persistent, volatile and potentially capable of explaining UK business cycles. The productivity term seems to be the dominant explanation of UK output fluctuations, while the estimated preference shift is crucial in understanding employment movements. A variety of Granger-causality tests are used to establish whether these productivity and preference terms are predictable, and so can be potentially considered as the ultimate cause of UK business cycles, or whether they are themselves Granger-caused by other variables.

The authors find that their estimated productivity term is not predicted by any demand-side variable, including various fiscal and monetary policy instruments, but to a limited extent it is predicted by oil prices and the share of taxes in GDP. This suggests that the productivity shock may also reflect other supply-side influences. In contrast, the preference term is strongly predicted 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 paper concludes with a discussion of the implications of these findings for competing theories of the business cycle and for the monetary transmission mechanism.

The Determinants of UK Business Cycles
Allison Holland and Andrew Scott