Trends and Cycles: An Historical Review of the Euro Area

Abstract

We analyze the euro area business cycle in a medium scale DSGE model where we assume two stochastic trends: one on total factor productivity and one on the inflation target of the central bank. To justify our choice of integrated trends, we test alternative specifications for both of them. We do so, estimating trends together with the model's structural parameters, to prevent estimation biases. In our estimates, business cycle fluctuations are dominated by investment specific shocks and preference shocks of households. Our results cast doubts on the view that cost push shocks dominate economic fluctuations in DSGE models and show that productivity shocks drive fluctuations on a longer term.

As a conclusion, we present our estimation's historical reading of the business cycle in the euro area. This estimation gives credible explanations of major economic events since 1985.

Keywords: New Keynesian model, Business Cycle, Bayesian estimation

JEL Classification: E32