Suppose we adopt the old-school NBER-style definition of a recession – i.e. we know we’re in a recession when we have 2 quarters of negative GDP growth.
Consider the statement: Because recessions occur when GDP growth is negative, we expect that interest rates will always be low during recessions.
Explain why this statement is ambiguous
Hint: timing is crucial here. Imagine 2 small countries. In one you look at ∆c_(t+1) and find a very strong sine-wave like “business cycle” pattern. In another you find ∆c_(t+1) to be very persistent (say an AR(1) with p=0.9) but has no obvious cyclical pattern. Why might interest rates tend to be low during recessions in one country and higher in the other.