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Univariate vs. Multivariate Forecasts of GNP Growth and Stock Returns: Evidence and Implications for the Persistence of Shocks, Detrending Methods

  • John H. Cochrane

Lagged GNP growth rates are poor forecasts of future GNP growth rates in postwar US data, leading to the impression that GNP is nearly a random walk. However, other variables, and especially the lagged consumption/GNP ratio, do forecast long-horizon GNP growth, and show that GNP has temporary components. Labor income and stock prices (using the dividend/price ratio) display the same behavior. This paper documents these facts and examines their implications for the persistence of shocks to GNP and time-variation in expected stock returns. I find that GNP has an almost entirely transitory response to a GNP shock that holds consumption constant. This is intuitive: if consumption does not change, permanent income did not change, so the change in GNP should be transitory. Similarly, a stock price shock that holds dividends constant suggests a discount rate change, and prices display a large transitory movement in response to this shock. The paper also examines implications of transitory variations in GNP and labor income for methods of extracting stochastic trends or "cyclically adjusting" GNP, and for explaining "excess smoothness" violations of the permanent income hypothesis.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 3427.

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Date of creation: Sep 1990
Date of revision:
Publication status: published as "Permanent and Transitory Components of GNP and Stock Prices," Quarterly Journal of Economics, pp. 241-265 (February 1994).
Handle: RePEc:nbr:nberwo:3427
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  1. King, Robert G. & Plosser, Charles I. & Stock, James H. & Watson, Mark W., 1991. "Stochastic Trends and Economic Fluctuations," American Economic Review, American Economic Association, vol. 81(4), pages 819-40, September.
  2. Clark, Peter K, 1987. "The Cyclical Component of U.S. Economic Activity," The Quarterly Journal of Economics, MIT Press, vol. 102(4), pages 797-814, November.
  3. Campbell, John Y & Mankiw, N Gregory, 1987. "Are Output Fluctuations Transitory?," The Quarterly Journal of Economics, MIT Press, vol. 102(4), pages 857-80, November.
  4. Cogley, T., 1989. "International Evidence On The Size Of The Random Walk In Output," Discussion Papers in Economics at the University of Washington 89-02, Department of Economics at the University of Washington.
  5. Hodrick, Robert J, 1992. "Dividend Yields and Expected Stock Returns: Alternative Procedures for Inference and Measurement," Review of Financial Studies, Society for Financial Studies, vol. 5(3), pages 357-86.
  6. Kenneth D. West, 1987. "The Insensitivity of Consumption to News About Income," NBER Working Papers 2252, National Bureau of Economic Research, Inc.
  7. Cochrane, John H, 1988. "How Big Is the Random Walk in GNP?," Journal of Political Economy, University of Chicago Press, vol. 96(5), pages 893-920, October.
  8. Campbell, John & Deaton, Angus, 1989. "Why Is Consumption So Smooth?," Scholarly Articles 3221494, Harvard University Department of Economics.
  9. Fama, Eugene F & French, Kenneth R, 1988. "Permanent and Temporary Components of Stock Prices," Journal of Political Economy, University of Chicago Press, vol. 96(2), pages 246-73, April.
  10. Cochrane, John H. & Sbordone, Argia M., 1988. "Multivariate estimates of the permanent components of GNP and stock prices," Journal of Economic Dynamics and Control, Elsevier, vol. 12(2-3), pages 255-296.
  11. Nelson, Charles R. & Plosser, Charles I., 1982. "Trends and random walks in macroeconmic time series : Some evidence and implications," Journal of Monetary Economics, Elsevier, vol. 10(2), pages 139-162.
  12. Beveridge, Stephen & Nelson, Charles R., 1981. "A new approach to decomposition of economic time series into permanent and transitory components with particular attention to measurement of the `business cycle'," Journal of Monetary Economics, Elsevier, vol. 7(2), pages 151-174.
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