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Permanent vs Transitory Components and Economic Fundamentals

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  • Anthony Garratt

    (Department of Economics, Mathematics & Statistics, Birkbeck)

  • Donald Robertson
  • Stephen Wright

    (School of Economics, Mathematics & Statistics, Birkbeck)

Abstract

Any non-stationary series can be decomposed into permanent (or "trend") and transitory (or "cycle") components. Typically some atheoretic pre-filtering procedure is applied to extract the permanent component. This paper argues that analysis of the fundamental underlying stationary economic processes should instead be central to this process. We present a new derivation of multivariate Beveridge-Nelson permanent and transitory components, whereby the latter can be derived explicitly as a weighting of observable stationary processes. This allows far clearer economic interpretations. Different assumptions on the fundamental stationary processes result in distinctly different results; but this reflects deep economic uncertainty. We illustrate with an example using Garratt et al's (2003a) small VECM model of the UK economy. Any non-stationary series can be decomposed into permanent (or "trend") and transitory (or "cycle") components. Typically some atheoretic pre-filtering procedure is applied to extract the permanent component. This paper argues that analysis of the fundamental underlying stationary economic processes should instead be central to this process. We present a new derivation of multivariate Beveridge-Nelson permanent and transitory components, whereby the latter can be derived explicitly as a weighting of observable stationary processes. This allows far clearer economic interpretations. Different assumptions on the fundamental stationary processes result in distinctly different results; but this reflects deep economic uncertainty. We illustrate with an example using Garratt et al's (2003a) small VECM model of the UK economy.

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File URL: http://www.bbk.ac.uk/ems/research/wp/PDF/BWPEF0501.pdf
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Bibliographic Info

Paper provided by Birkbeck, Department of Economics, Mathematics & Statistics in its series Birkbeck Working Papers in Economics and Finance with number 0501.

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Date of creation: Jan 2005
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Handle: RePEc:bbk:bbkefp:0501

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Keywords: Multivariate Beveridge-Nelson; VECM; Economic Fundamentals; Decomposition.;

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  1. Andrew C. Harvey & Thomas M. Trimbur, 2003. "General Model-Based Filters for Extracting Cycles and Trends in Economic Time Series," The Review of Economics and Statistics, MIT Press, vol. 85(2), pages 244-255, May.
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  3. Vahid, F & Engle, Robert F, 1993. "Common Trends and Common Cycles," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 8(4), pages 341-60, Oct.-Dec..
  4. James C. Morley & Charles R. Nelson & Eric Zivot, 2003. "Why Are the Beveridge-Nelson and Unobserved-Components Decompositions of GDP So Different?," The Review of Economics and Statistics, MIT Press, vol. 85(2), pages 235-243, May.
  5. Anthony Garratt & Kevin Lee & M. Hashem Pesaran & Yongcheol Shin, 2003. "A Long run structural macroeconometric model of the UK," Economic Journal, Royal Economic Society, vol. 113(487), pages 412-455, 04.
  6. Arino, Miguel A. & Newbold, Paul, 1998. "Computation of the Beveridge-Nelson decomposition for multivariate economic time series," Economics Letters, Elsevier, vol. 61(1), pages 37-42, October.
  7. Engle, Robert F & Kozicki, Sharon, 1993. "Testing for Common Features," Journal of Business & Economic Statistics, American Statistical Association, vol. 11(4), pages 369-80, October.
  8. Rotemberg, Julio J & Woodford, Michael, 1996. "Real-Business-Cycle Models and the Forecastable Movements in Output, Hours, and Consumption," American Economic Review, American Economic Association, vol. 86(1), pages 71-89, March.
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  11. James C. Morley & Charles Nelson & Eric Zivot, 2000. "Why Are Beveridge-Nelson and Unobserved-Component Decompositions of GDP So Different?," Working Papers 0013, University of Washington, Department of Economics.
  12. Robert G. King & Charles I. Plosser & James H. Stock & Mark W. Watson, 1991. "Stochastic trends and economic fluctuations," Working Paper Series, Macroeconomic Issues 91-4, Federal Reserve Bank of Chicago.
  13. Morten O. Ravn & Harald Uhlig, 2002. "On adjusting the Hodrick-Prescott filter for the frequency of observations," The Review of Economics and Statistics, MIT Press, vol. 84(2), pages 371-375.
  14. Newbold, Paul, 1990. "Precise and efficient computation of the Beveridge-Nelson decomposition of economic time series," Journal of Monetary Economics, Elsevier, vol. 26(3), pages 453-457, December.
  15. Sharon Kozicki & P.A. Tinsley, 2001. "Dynamic specifications in optimizing trend-deviation macro models," Research Working Paper RWP 01-03, Federal Reserve Bank of Kansas City.
  16. Gonzalo, Jesus & Granger, Clive W J, 1995. "Estimation of Common Long-Memory Components in Cointegrated Systems," Journal of Business & Economic Statistics, American Statistical Association, vol. 13(1), pages 27-35, January.
  17. William J. Crowder & Dennis L. Hoffman & Robert H. Rasche, 1999. "Identification, Long-Run Relations, and Fundamental Innovations in a Simple Cointegrated System," The Review of Economics and Statistics, MIT Press, vol. 81(1), pages 109-121, February.
  18. Evans, George & Reichlin, Lucrezia, 1994. "Information, forecasts, and measurement of the business cycle," Journal of Monetary Economics, Elsevier, vol. 33(2), pages 233-254, April.
  19. Garratt, Anthony & Kevin Lee & M Hashem Pesaran & Yongcheol Shin, 2002. "Forecast Uncertainties In Macroeconometric Modelling: An Application to the UK Economy," Royal Economic Society Annual Conference 2002 82, Royal Economic Society.
  20. Engle, Robert F & Kozicki, Sharon, 1993. "Testing for Common Features: Reply," Journal of Business & Economic Statistics, American Statistical Association, vol. 11(4), pages 393-95, October.
  21. Kozicki, Sharon, 1999. "Multivariate detrending under common trend restrictions: Implications for business cycle research," Journal of Economic Dynamics and Control, Elsevier, vol. 23(7), pages 997-1028, June.
  22. Cochrane, John H, 1994. "Permanent and Transitory Components of GNP and Stock Prices," The Quarterly Journal of Economics, MIT Press, vol. 109(1), pages 241-65, February.
  23. Scott, Alasdair, 2003. "APPLIED MACROECONOMETRICS Carlo A. Favero Oxford University Press, 2001," Macroeconomic Dynamics, Cambridge University Press, vol. 7(02), pages 313-315, April.
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