How Large Is the Cost of Business Cycles in Developing Countries?

• Author: Masahiro Kodama
• Published date: 01 February 2013
• Date: 01 February 2013
• DOI: http://doi.org/10.1111/rode.12014

How Large Is the Cost of Business Cycles in

Developing Countries?

Masahiro Kodama*

Abstract

This study measures the cost of business cycles in developing countries.The business-cycle component of

consumption is extracted by employing a detrending filter adjusted for the length of a subject country’s

business cycles, rather than a standard detrending filter,and the cost of business cycles using the extracted

component is extracted. Estimated costs in developing countries based on the adjusted filter are found to be

significantly different from those based on the standard filter. Hence, in measuring the costs of business

cycles in developing countries, we should be careful about the choice of a detrending filter.The results also

indicate the following findings: 1) in developing countries,there is probably more room to improve the cost

of non-business-cycle fluctuations than that of business-cycle fluctuations,and 2) the cost of business cycles

is not strikingly large, even when it is estimated from a model strongly disfavoring business cycles.

1. Introduction

The cost of business cycles is an index that represents the welfare loss that originates

from business cycles. In this research, we measure the cost of business cycles in devel-

oping countries. Since the Great Depression,research on business cycles has been one

of the most important research fields in macroeconomics and many aspects of busi-

ness cycles have been studied. For example, Lucas (1987), Obstfeld (1994), van

Wincoop (1994), Dolmas (1998), Campbell (1999), Tallarini (2000), Otrok (2001) and

many others examine the cost of business cycles in industrialized countries. While

each of these studies greatly contributes to the research field, studies on the cost of

business cycles in developing countries are very limited. Pallage and Robe (2003, PR

hereafter), contribute to the literature by measuring the cost of business cycles in

developing African countries.1PR measure these costs using a standard detrending

filter originally developed for extracting the United States’ business-cycle component.

Meanwhile, Rand and Tarp (2002) empirically find that the lengths of the business-

cycles in developing countries are significantly different from those of the US.As we

will see in section 2, it is expected that the standard detrending filter may not appro-

priately extract the business-cycle component if the subject country’s business-cycle

length is significantly different from that of the US. Eventually, it is possible that the

cost of the business cycles calculated from the extracted business-cycle component is

clearly different from the costs measured by PR. We now question how large the cost

of the business cycles is if we consider the differences in the business-cycle lengths.In

this paper, we address this unresolved research question.

PR also find that in some cases, using a model with an Epstein–Zin (1989) utility

function, the cost of the total fluctuations (the total of the business-cycle and non-

* Kodama: Institute of Developing Economies, 3-2-2, Wakaba, Mihama-ku, Chiba, 261-8545, Japan. Tel: +81-

43-299-9500; Fax: +81-43-299-9724; E-mail: mkodama@ide.go.jp. The author is grateful to Toshihisa Toyoda

and Koji Kawabata, and two anonymous referees for their invaluable comments. Responsibility for any

errors in the article lies solely with the author.

Review of Development Economics, 17(1), 49–63, 2013

DOI:10.1111/rode.12014

© 2013 Blackwell Publishing Ltd