BIS Working Papers No 1076 The shape of business cycles: a cross-country analysis of Friedman’s plucking theory by Emanuel Kohlscheen, Richhild Moessner and Daniel M Rees Monetary and Economic Department February 2023 JEL classification: E24; E32. Keywords: business cycle, growth, labour market, unemployment. BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The papers are on subjects of topical interest and are technical in character. The views expressed in them are those of their authors and not necessarily the views of the BIS. This publication is available on the BIS website (www.bis.org). © Bank for International Settlements 2023. All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated. ISSN 1020-0959 (print) ISSN 1682-7678 (online) 1 The shape of business cycles: a cross-country analysis of Friedman’s plucking theory Emanuel Kohlscheen, Richhild Moessner and Daniel M. Rees 1 Abstract We test the international applicability of Friedman’s famous plucking theory of the business cycle in 12 advanced economies between 1970 and 2021. We find that in countries where labour markets are flexible (Australia, Canada, United Kingdom and United States), unemployment rates typically return to pre-recession levels, in line with Friedman’s theory. Elsewhere, unemployment rates are less cyclical. Output recoveries differ less across countries, but more across episodes: on average, half of the decline in GDP during a recession persists. In terms of sectors, declines in manufacturing are typically fully reversed. In contrast, construction-driven recessions, which are often associated with bursting property price bubbles, tend to be persistent. JEL Classification: E24; E32. Keywords: business cycle; growth; labour market; unemployment 1 Bank for International Settlements, Centralbahnplatz 2, 4002 Basel, Switzerland. We are grateful to Egon Zakrajšek for helpful comments and suggestions and Emese Kuruc for excellent research assistance. The views expressed in this paper are those of the authors and do not necessarily reflect those of the Bank for International Settlements. 2 1. Introduction Are economic recoveries from recessions complete? If not, what characteristics influence the extent of recoveries? In this article, we present novel cross-country evidence on the shape of business cycles across advanced economies. We compare the patterns that are found with the predictions of Milton Friedman’s “plucking theory” of the business cycle (see Friedman (1964, 1993)). This theory was recently revived by the influential paper of Dupraz et al (2019).2 Our analysis is based on twelve advanced economies (AEs), covering a total of more than 50 recessions since 1970.3 Recessions in each country are timed using the same timing algorithm, following Bry and Boschan (1971) and Harding and Pagan (2003). Our central finding is that in countries with flexible labour markets post-recession declines in the unemployment rate almost fully reverse the effects of recessions. In other words, recoveries in these follow a fairly predictable pattern. Further, the unemployment rate declines in expansions bear no relation with rises in subsequent recessions. This pattern is broadly consistent with Friedman’s plucking theory of the business cycle. Yet, in the two thirds of countries with less flexible labour markets unemployment rates are far less cyclical. In contrast, output recoveries differ less across countries but more across episodes. Many recessions leave permanent scars. It is important to note here that, throughout, we focus on the magnitude of output and employment declines and subsequent recoveries, rather than looking at the timing or cause of turns in the business cycle.4 2. Dating business cycles across countries Figure 1 shows the timeline of all economic expansions in twelve AEs since 1970. Expansions and recessions were timed by applying the Bry-Boschan-Harding-Pagan procedure to quarterly time series of seasonally adjusted real GDP.5 For countries where commonly-accepted recession dates exist (as in the United States), the timeline aligns closely with those sources. 2 Kim and Nelson (1999) state that in Friedman’s plucking view, “recessions are like common cold: they come on suddenly and recovery follows a fairly predictable course, but the time that has passed since the last cold is of no use in predicting when the next will occur, or its severity.” 3 Australia, Canada, France, Germany, Italy, Japan, Norway, Spain, Sweden, Switzerland, the United Kingdom and the United States. Country selection wa