Two Flaws In Business Cycle Accounting∗

Using ‘business cycle accounting’ (BCA), Chari, Kehoe and McGrattan (2006) (CKM) conclude that models of financial frictions which create a wedge in the intertemporal Euler equation are not promising avenues for modeling business cycle dynamics. There are two reasons that this conclusion is not warranted. First, small changes in the implementation of BCA overturn CKM’s conclusions. Second, one way that shocks to the intertemporal wedge impact on the economy is by their spillover effects onto other wedges. This potentially important mechanism for the transmission of intertemporal wedge shocks is not identified under BCA. CKM potentially understate the importance of these shocks by adopting the extreme position that spillover effects are zero. ∗The first author is grateful for the financial support of a National Science Foundation grant. We are grateful for several key discussions with Mark Gertler, as well as for discussions with Martin Eichenbaum. †Northwestern University, National Bureau of Economic Research. ‡Northwestern University.