New Evidence on Balanced Growth, Stochastic Trends, and Economic Fluctuations

The one-sector Solow-Ramsey growth model informs how most modern researchers characterize macroeconomic trends and cycles, and evidence supporting the model’s balanced growth predictions is often cited. This paper shows, however, that the inclusion of recent data leads to the balanced growth predictions being rejected. An alternative balanced growth hypothesis—that the ratio of nominal consumption to nominal investment is stationary—is put forward, and new measures of the stochastic trends and cycles in aggregate US data are derived based on this hypothesis. The contrasting behavior of real and nominal ratios is consistent with a two-sector model of economic growth, with separate production technologies for consumption and investment and two stochastic trends underlying the long-run behavior of all macroeconomic series. Empirical estimates of these stochastic trends are presented based on a structural VAR and the role played in the business cycle by shocks to these trends is discussed. ∗E-mail: [email protected]. The views expressed in this paper are my own and do not necessarily reflect those of the Central Bank and Financial Services Authority of Ireland or the ESCB.