What Causes Business Cycles? Analysis of the Japanese Industrial Production Data

TL;DR

This paper analyzes Japanese industrial production data using spectral and factor analysis, identifying aggregate demand and inventory adjustments as key drivers of business cycles, with demand shocks being the primary cause.

Contribution

It introduces a novel application of spectral and factor analysis with random matrix theory to identify demand and inventory factors as main causes of business cycles.

Findings

Two dominant factors identified: aggregate demand and inventory adjustment.

Shipments lead production by four months.

Model remains robust during the 2008-09 recession.

Abstract

We explore what causes business cycles by analyzing the Japanese industrial production data. The methods are spectral analysis and factor analysis. Using the random matrix theory, we show that two largest eigenvalues are significant. Taking advantage of the information revealed by disaggregated data, we identify the first dominant factor as the aggregate demand, and the second factor as inventory adjustment. They cannot be reasonably interpreted as technological shocks. We also demonstrate that in terms of two dominant factors, shipments lead production by four months. Furthermore, out-of-sample test demonstrates that the model holds up even under the 2008-09 recession. Because a fall of output during 2008-09 was caused by an exogenous drop in exports, it provides another justification for identifying the first dominant factor as the aggregate demand. All the findings suggest that the major cause of business cycles is real demand shocks.