1 Introduction
The Lebanese economy has practiced wide and irregular fluctuations of its GDP over the period 1970–2015. The GDP growth rate has reached 12.5% in 1972 to drop 58% in 1976 with the beginning of the Lebanese civil war, to increase by 83% at the end of 1990. However, starting the after-war reconstruction in 1997, the real GDP growth rate has oscillated over the period 1999–2015, from below 0% level in 1999 to 2.57% in 2009 (see Fig.
3).
On the other hand, since 1992, the Lebanese economy was characterized by a high level of dollarization as a consequence of hyperinflation. To control the inflation rate, the Lebanese monetary authorities have adopted the fixed exchange rate regime in 1997 administrating the Lebanese currency price. Thus, to maintain the Lebanese currency parity against the dollar within a very narrow limit, the Central Bank offered high interest rates on Lebanese treasury bills. The cost of fixing the Lebanese currency added to the cost of reconstruction after the civil war, and the Israeli continual attacks to south Lebanon have produced a permanent budget deficit and contributed to increase the public debts to alarming level. The public debts GDP ratio is equivalent to 185% in 2015.
What causes GDP fluctuations? The Keynesian view line theoreticians advocated the role of monetary and argued that short-run fluctuations in employment and output are largely caused by variations in aggregate demand. However, Lucas (
1972,
1977) pointed to the shortcoming of the Keynesian approach and provides a theoretical groundwork for the notion of “monetary policy ineffectiveness” by integrating the rational expectations to the economic model. Friedman and Schwartz (
1963) postulated a link between monetary policy and real economic activity. Consequently, the monetarist leaders explained that monetary authorities should prevent excessive expansion of the money supply to maintain price stability.
The aim of this paper is to identify the Lebanese business cycle over the period 1998–2015 and to explore how aggregate activity in Lebanon fluctuates with recurrent shocks. In other terms, this paper investigates how the output fluctuates around the trend level that reflects the business cycles amplitude and duration. Moreover, this paper discusses whether the adopted monetary policy in Lebanon had succeeded to smooth the business cycles or not? The assessment of the causality relation between the capacity utilization rate and inflation allows to answer whether monetary disturbances matter for business cycle.
As in Cogley and Nason (
1995), this paper uses Hodrick Prescott filter to identify Lebanese business cycle. However, Granger causality test is used to evaluate the relationship between the capacity utilization rate and the inflation in the short run, while OLS method is applied to assess this relation in the long run. This paper is organized as follows: Sect.
2 presents the empirical literature review. Section
3 presents the Hodrick Prescott Filter results and analysis for the Lebanese GDP followed in Sect.
4 by an analysis to the relationship between the capacity utilization rate and inflation variables to conclude in Sect.
5. All the tests are performed using EViews.
2 From cycle definition to economic models
An overview of the world history shows incessant series of recurrent cycles with either uniformities or variabilities. The history repeats itself, and it goes through cycles in almost everything: climate, economy, war, geopolitics, life and so on. Thus, the academic world of the historiography describes a cyclical view of history analyzing the cycles of episodes since the nineteenth century. However, the originators of this analysis were the Genius Ibn Khaldun (
1371).
In his famous book “Al Muqaddimah” written in 1371, Ibn Khaldun recorded an early view of the history and established a coherent economic theory that explains and predicts the rise and fall of all empires, nations and civilizations, through the study of their life cycles. He explained that empires are like organisms and their life trajectories can be plotted like points in a bell curve from their beginnings to their deaths.
Mitchell (
1927) presented a descriptive approach to cycle which encompasses the decomposition of a wide number of time series into sequences of cycles. Explaining the major fact about cycles is the recurrent nature of the events; he divided each cycle into four different stages, unavoidably progressing from one into another: expansion, peak, contraction and trough. However, Burns and Mitchell (
1946) presented a more detailed definition of business cycle where they compared cycle to “a type of fluctuations found in the aggregate economic activity of nations that organize their work mainly in business enterprises.” Nonetheless, in the conventional model of the economy, the business cycle is represented as fluctuations of actual GDP around a smooth trendline. The duration of these fluctuations can last from a few quarters to several years.
Investigating the sources of GDP fluctuations, economists are divided into two main groups supported by empirical works. Keynes (
1936) as well as a group of economists attached to its school point to the monetary disturbances as source of business cycle. Consequently, using time series techniques, Christiano and Eichenbaum (
1992) accumulate evidences which support the important role of monetary policy in determining aggregate output, employment and other macroeconomic factors. Alternatively, a second group, related to classical school, advocates that business cycles are generated by that non-monetary factors. In this line of view, Baxter and King (
1993) present an empirical work which decomposes the GDP time series into periodic components by regressing the time series in a set of sine and cosine waves to conclude that fiscal shocks count in expressing business cycles fluctuations.
However, the rational expectation idea initiated by Muth (
1961) inspired Robert Lucas to develop in 1972 the rational expectation theory which emphasizes the monetary policy ineffectiveness. Luca (
1972) explained that that policymakers can guide the economy by systematically influencing the economic agents to make false expectations. Thus, in contrast with the Keynesian perspective, where policy offers relief from unemployment and market failures, Luca clarified that, in a world of rational expectations and market clearing, monetary policy is not the primary source of macroeconomic instability and that only unanticipated monetary shocks can have real effects on real variables. Furthermore, he explained that policies which try to manipulate the economy by persuading economic agents to false expectations do not improve the economy’s performance, but generate “noise” making economic decisions and adjustment more complicated. Nevertheless, while accepting Keynesian economics, the monetarist theoreticians explained that excessive expansion of the money supply is fundamentally inflationary.
Otherwise, in the line of Shumpeter (
1927) who has developed a theory of business cycles which puts its emphasis on industrial innovation rather than monetary sector, classical economists have developed the real business cycle model (RBC) which advocates the role of technology shocks as a cause of economic fluctuations and limits the role of monetary factors in generating these economic fluctuations. The RBC ties a theory of economic growth, behavioral model of economic agents based on the utility maximization and an explanation of the business cycle. In other terms, it integrates both the growth (Solow (
1956) Model) and the business cycles theory to confirm that business cycle fluctuations are the optimal responses to unanticipated supply shocks defined by the total factor productivity.
However, Kydland and Prescott (
1982) proposed a theory of business cycle fluctuations far from the Keynesian tradition. Integrating growth and business cycle theory, they characterized a general macroeconomic equilibrium model to predict the consequence of a policy rule upon the operating characteristics of the economy. This simple model, based on microeconomic foundations and where there is no role for monetary factors, generates quantitatively significant business cycles. They argued that periods of temporarily low output growth are not the results of market failure to clear, but could simply be a supply shock where slow improvements in production technologies appear.
Furthermore, Cooley and Hansen (
1989) proved, in a cash-in-advance real business cycle model, that adding monetary factors made little difference to the results, which assumes a minimal role for monetary aggregates. King et al. (
1988) implemented a structural model for business cycle to conclude that business cycles are mutually determined by growth. Nelson and Plosser (
1982) argued that the long-run path of macroeconomy is permanently affected by contemporary events; their empirical work demonstrates that the hypothesis that GDP growth follows a random walk cannot be rejected. In other terms, that most of the changes in GDP were permanent, and that output growth would not revert to an underlying trend following a shock. Thus, changes in aggregate demand—the heart of Keynesian macroeconomics—must be of relatively little importance.
Nevertheless, the conflict between normative implications and policy practice on one hand and between theoretical predictions and evidence on other hand is considered as an indication that some fundamentals that are essential in actual economies may be missing in classical monetary models. To overcome these deficiencies, a group of economists, while maintaining the RBC as an underlying structure, introduces Keynesian assumptions to produce economic models. Consequently, the progress in economic research combined classical and Keynesian principles to develop the New Keynesian view. Thus, Keynesian elements as imperfect competition and nominal rigidities were incorporated into a dynamic model to analyze the connection between inflation, money and the business cycle. Equilibrium conditions for aggregate variables are resulting from optimal individual behavior regarding consumers and firms as well they are consistent with the immediate markets’ clearing. From that point of view, the new generation of Keynesian models has much stronger theoretical foundations than traditional ones. However, the stressing on the nominal rigidities as being a source of monetary non-neutralities provides an important differentiation between classical monetary model frameworks and new Keynesian models.
The emphasizing on the nominal rigidities as being a source of non-neutralities affords an important differentiation between classical monetary frameworks and new Keynesian models. Despite their different theoretical basics, there are important connections between the RBC models and the new Keynesian monetary model. These similarities are reflected in the assumption of an infinitely lived representative household, who seeks to maximize the utility from consumption and leisure, subject to an intertemporal budget constraint and large number of firms with access to an identical technology, subject to exogenous random shifts. Nevertheless, some key elements of RBC theory are missing in the canonical version of new Keynesian model, like the endogenous capital accumulation.
Thus, Mankiw (
1989), in his famous paper “Real Business Cycles: A New Keynesian Perspective” developed a New Keynesian assumption. He considered that money has a primary role to explain the fluctuations of business cycles. Furthermore, he assumed that economic recessions are not caused by technological shocks, since economic agents are rational and response to any technological downturn causing a recession.
Though, Rotemberg and Woodford (
1996) introduced imperfect competitive product markets into a standard neoclassical growth model to analyze the effects of imperfect competition upon the economy’s response to many types of real shocks including the technology shock. Their findings proved that imperfect competition affects the way in which the economy responds to several shocks which may occur.
Furthermore, Goodfriend and King (
1997) in line with the New Keynesian paradigm developed the new neoclassical synthesis (NNS). Merging Keynesian and classical elements, they produced the systematic application of intertemporal optimization and rational expectations as stressed by Robert Lucas proving that the evolution of inflation in the NNS models depends on current and expected future markups. Moreover, their findings specify that considering an NNS model, the near-zero inflation rate targeting is possible.
Nonetheless, a group of economists characterized business cycles by a dynamic stochastic general equilibrium (DSGE) models. These models are based on microeconomic foundations which emphasize that all agents are rational and make decisions based on intertemporal optimization under uncertainty. In other terms, economic agents’ decisions today depend on their expectations on future uncertain outcomes. Thus, Smets and Wouters (
2003) developed a dynamic stochastic general equilibrium (DSGE) model with sticky wages and prices for the eurozone using Bayesian estimation techniques. Their model incorporates a variable capital utilization rate, while findings prove a considerable degree of price stickiness in the eurozone. However, Christiano et al. (
2005) used a DSGE model along with staggered wages and price contracts to investigate the evidence of output persistence and inflation inertia that occurs under a mix of frictions. After policy shock, the model generates persistent response in output and inertial response in inflation. Furthermore, findings prove that after the hit of a monetary policy shock, the money growth rate and the interest rate move persistently in reverse directions.
This paper applies Hodrick Prescott (HP) filter to derive the output trend and the output gap. However, a positive gap is related to the nonuse of capacity utilization, while a negative gap is related to the total use of capacity utilization implying an increase in demand and in inflation as results. This paper analyzes therefore the relation between capacity utilization rate and inflation in the short and long run to conclude empirically on the relation between Lebanese monetary policy and business cycle.
5 Conclusion
Hodrick Prescott filter applied on the quarterly time series of the Lebanese GDP over the period 1998-2015 shows a low average growth rate of the potential output trend (0.995%). This weakness in growth is attributed to not only politic disturbances but also the choice of production technology and the organizational innovation knowledge. Thus, monetary disturbances are not the source of Lebanese cycle but real shocks. To enhance economic growth, the Lebanese economy should undertake investments in new technologies, improvements in technical efficiency as adopting new methods of production, arranging for labor quality improvement, managing capital allocation and deepening and finally increasing returns to scale.
However, since the low level of the Lebanese utalization rate capacity, findings fail to prove a long-run relationship between utilization rate and inflation for the Lebanese economy over the studied period.
Thus, the role of monetary factors on business cycle disturbance is empirically proved for the Lebanese economy in the short run, but the applied tests results fail to prove a long-run relationship between monetary factors and business cycle fluctuations.