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A steady-state approach to trend/cycle decomposition of regime-switching processes

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  • James Morley
  • Jeremy M. Piger

Abstract

In this paper, we present a new approach to trend/cycle decomposition under the assumption that the trend is the permanent component and the cycle is the transitory component of an integrated time series. The permanent component is defined as the steady-state level of the series, a definition that has exploitable forecasting implications useful for identification. We operationalize the steady-state approach for regime-switching processes and we use generated data from such processes to demonstrate the advantages of the steady-state approach over alternative approaches to trend/cycle decomposition. We then apply the steady-state approach to estimate the trend and cycle of U.S. real GDP implied by a regime-switching forecasting model. Our findings portray a very different picture of the business cycle than implied by more traditional methods.

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Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2004-006.

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Date of creation: 2005
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Handle: RePEc:fip:fedlwp:2004-006

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Keywords: Time-series analysis ; Business cycles;

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  1. Kim, Chang-Jin, 1994. "Dynamic linear models with Markov-switching," Journal of Econometrics, Elsevier, Elsevier, vol. 60(1-2), pages 1-22.
  2. Clarida, Richard H. & Mark P. Taylor, 2002. "Nonlinear Permanent -Temporary Decompositions in Macroeconomics and Finance," Royal Economic Society Annual Conference 2002, Royal Economic Society 51, Royal Economic Society.
  3. Hamilton, James D, 1989. "A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle," Econometrica, Econometric Society, Econometric Society, vol. 57(2), pages 357-84, March.
  4. Hodrick, Robert J & Prescott, Edward C, 1997. "Postwar U.S. Business Cycles: An Empirical Investigation," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 29(1), pages 1-16, February.
  5. Chang-Jin Kim & James Morley & Jeremy Piger, 2003. "Nonlinearity and the permanent effects of recessions," Working Papers, Federal Reserve Bank of St. Louis 2002-014, Federal Reserve Bank of St. Louis.
  6. Clark, Peter K, 1987. "The Cyclical Component of U.S. Economic Activity," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 102(4), pages 797-814, November.
  7. Friedman, Milton, 1993. "The "Plucking Model" of Business Fluctuations Revisited," Economic Inquiry, Western Economic Association International, Western Economic Association International, vol. 31(2), pages 171-77, April.
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