Evaluating macroeconomic models of the business cycle

A wide range of different models can be used to analyse the behaviour of the economy over the cycle. While various diagnostic tools are available to discriminate between them, these are rarely conclusive. Consequently poor models survive alongside good ones. This paper develops the use of stochastic simulation techniques as a diagnostic device to assess the overall properties of models. The stochastic properties of the National Institute model are outlined, showing the extent to which it matches the business cycle moments of the UK economy and the persistence of the economic cycle. Its properties are compared with those of theory-based Real Business Cycle models and data-based VAR models. It is shown how structural economic models are needed to quantify the effect of appropriate choice of policy rules on the business cycle.