This paper tests the cycle is the trend hypothesis by investigating the ability of permanent and transitory productivity shocks to account for the dynamics observed in the South African business cycle over the period 1946–2014. To do this, we estimate a standard Small Open Economy Real Business Cycle (SOE-RBC) model and its financial frictions augmented counterpart using Bayesian techniques. The standard SOE-RBC model with permanent and transitory productivity shocks, also referred to as the benchmark SOE-RBC model, is augmented with a preference shock, a domestic spending shock, a country risk premium shock and debt elasticity of the country risk premium. This augmented model is referred to as the financial frictions SOE-RBC model.
The results show that permanent productivity shocks are more important than transitory ones in explaining business cycle fluctuations. The variance decompositions and the posterior estimates show that although the transitory, or stationary, productivity shock is more persistent than the permanent, or nonstationary, productivity shock in the model with financial frictions, it is the nonstationary productivity shock that explains most of the fluctuations in output growth observed in the data. Thus, the estimated results from the model with financial frictions overwhelmingly support the cycle is the trend hypothesis in the South African business cycle. The model also successfully mimics the downward sloping autocorrelation of the trade balance to output ratio observed in the data, whereas the benchmark model produces a flat autocorrelation function. The results further show that financial frictions such as the country risk premium shocks play an important role in explaining the fluctuations in investment and trade balance to output ratio.