You are on page 1of 26

# Chapter 5 Trends and cycles

Contents
Is there a trend? Stationary and non-stationary variables ........................................................................................ 2 Decomposing a variable into a trend and a cyclical component.............................................................................. 3 A deterministic, exponential trend........................................................................................................................... 4 Is the trend deterministic?................................................................................................................................ 7 Deterministic trend with ARMA model of the cycle....................................................................................... 8 Segmented deterministic trend ............................................................................................................................ 9 Continuously changing trends ............................................................................................................................... 10 Quadratic trend .................................................................................................................................................. 10 The Hodrick-Prescott trend ............................................................................................................................... 11 Stochastic trends.................................................................................................................................................... 14 Calculating a stochastic trend - ARIMA processes ....................................................................................... 15 The Beveridge-Nelson method for decomposing a variable into a stochastic trend and a cycle ................... 20 Conclusion and a suggested strategy for determining the trend model ................................................................. 23 Exercises................................................................................................................................................................ 24

Most economic variables increase steadily over time: there is a positive trend in the variable. In many cases we want to separate the long-term trend from short-term fluctuations. The short-term fluctuations are temporary (or cyclical) changes as opposed to the permanent changes reflected in the trend. A trend is used for two purposes:

1. The trend is used in a backward-looking perspective to explain what has happened by distinguishing between permanent and temporary changes.

2. The trend is used in a forward-looking perspective to predict what will happen in the long run, since temporary changes by definition will disappear.

In this chapter, we discuss trends from two perspectives: 1) how to model and simulate a trend, and 2) how to estimate a trend from real data.

## Is there a trend? Stationary and non-stationary variables

Before we set out to calculate a trend in a real data series, we must determine if there is a trend. A simple graphical method is the following, which is illustrated in Figure 5.1. A variable that contains a trend lacks a constant mean towards which it always comes back. We may test this by plotting the variable and its mean. If the variable only passes the mean once or twice, the variable contains a trend. If it passes the mean many times - it wiggles around the mean - it does not contain a trend.

If the variable passes the mean only a few times, the test cant tell if the variable contains a trend. If it passes the mean three times in the middle of the sample, however, it may still be reasonable to suppose there is a trend. This would be the case for GDP, if there were a deep recession in the middle of the sample.

A variable that contains a trend is called a non-stationary variable, as opposed to a stationary variable, which does not contain a trend. A stationary variables mean may be interpreted as a stable equilibrium value. When the variable deviates from the mean, it is pulled back by market forces to the equilibrium - the constant mean. There is a stationary level - a station towards which the variable always strives. A synonym for a stationary variable is a meanreverting variable. A stable equilibrium is called a resting point in physics. An example is the final position of a pendulum; if we disturb it, it will move back and forth around the resting point and eventually come to rest.

We may get an idea of the speed of adjustment by looking at the average time between mean passages. If the adjustment is slow, it takes a long time between the passages. This means that if we observe the variable for too short a time, we only see a few adjustment periods. That is why it is difficult to determine if a variable with only a few passages is stationary: it could just be slow adjustment. There are statistical tests that go some way to help, but essentially it is a data problem: with too short a time series relative to the adjustment period, we just cant tell if the variable always returns to the mean after it has been disturbed.

## Decomposing a variable into a trend and a cyclical component

If we find that there is a trend, which is the case for most economic variables, how should the trend be described? As a matter of definition, a variable is divided into the following components
y t = y ttrend + y tcycle + y tseason , { 1444 2444 3
Unobserved

(5.1)

Observed

where y without a superscript stands for the actual, observed value. 1 The components in themselves are unobserved. Normally, we do not find the trend- or the cyclical component in statistical publications. We must model the components ourselves or rely on somebody else.

Consider first the seasonal component. It is due to recurring ups or downs over the year. At a certain season the variable tends to be low, at another season it is high. Examples are production declines during summer vacations, and increases in consumption before Christmas. By definition, only daily, monthly, or quarterly data have a seasonal component. Computing the seasonal component is a difficult area which we leave out by considering only yearly data, that is, we simplify to y t = y ttrend + y tcycle .

(5.2)

Thus there are only two components. This means that if we find a way to compute the trend, we simply compute the cyclical component by subtracting the trend from the actual value: y tcycle = y t y ttrend .

A method for trend calculation is thus also a method of calculating the cyclical component when we use yearly data.

Statisticians sometimes consider a fourth, random component. Macroeconomists generally consider the random component a part of the cyclical component, which thus in itself is random.

There are different methods to model a trend. We will discuss the economic significance of the different methods and how we can test which method is the most appropriate. The question is not just a technical issue, but a vital question of how growth, as reflected in the trend, occurs. And as a certain trend implies a certain cyclical component, it also determines how we interpret the business cycle. Much research during the 1980s went into the proper way to decompose GDP into its trend and its cyclical component. One motivation is the traditional idea that the trend and the cycle are determined by different factors: the trend by growth in factor productivity and growth of factors, and the cycle by shifts in aggregate demand. If it is found that trends fluctuates a lot, as many have argued in the 1980s, a lot of the fluctuations in actual GDP are due to fluctuations in the trend. There is then little scope for stabilization policy to affect the cyclical component through aggregate demand policies. No consensus has been reached on the best method and, as we shall see, it is not easy to choose between the methods.

The trend models may be divided according to if the trend is constant or changing. If the trend is changing, it may do so in different ways. It may change continuously or with sudden jumps. If it changes in jumps, these may be large and occur seldom, or be small and occur often. After discussing each of these possibilities, we present a step-by-step procedure to determine which method is appropriate.

## A deterministic, exponential trend

This method has long been the standard method. The trend is supposed to grow at a constant relative growth rate r each year (if r=0.03, the growth rate in percent is 3 percent). Each period y trend increases by r times y at the beginning of the period:

## Collect terms to get

y ttrend =(1 + r ) y ttrend 1 .

(5.3)

With knowledge of r, we can successively compute new trend values by multiplying the previous trend value with (1+r) from a known starting value of the trend.

This implies that an initial trend value and the growth rate determines the whole future path.
trend Formally, lag (5.3) one period: y ttrend =(1 + r ) y ttrend 1 2 . Replace y t 1

in (5.3), by (1 + r ) y ttrend 2

## to get y t = y t 2 (1 + r ) 2 . Continuing back in time, it must be the case that

y ttrend =(1 + r ) k y ttrend k .

(5.4)

## The trend thus follows the rule of compound interest.

To apply (5.3) or (5.4) with real data, we must first estimate the growth rate, r, of the trend. There are two basic methods: 1) fitting a trend between a start and an end trend value, and 2) fitting a trend with so called regression. The first method gives an exact expression for the average growth rate between two points in time. The methods may be applied to either original data or to their natural logarithms. In a spreadsheet, you plug in the initial trend-value and then copy down either formula (5.3) or (5.4).

## Method 1. Fitting a trend between a start and an end trend value

Original data. We assume that the actual and trend values coincide at points near the start and the end of the series. We may have other information to indicate that actual GDP was close to the trend, for example that unemployment was at its average value. To find the growth rate, divide both sides in (5.12) by GDPt k and raise both sides to the power of 1/k ("take the k:th root"):

yt 1 + r = y t k

k .

The average growth rate, r, is the k:th root of the ratio between the end- and the start value minus one, where t is the number of years between the start and the end. Thus, to calculate the

average growth rate between two points you do not need the intervening values. Intuitively, the shape of the evolution between the start and the end does not matter. Once you have the growth rate r, apply (5.4), or calculate the trend-values successively from the start value as in (5.3). The method is illustrated in Figure 5.2a.

ln y t ln y 0 t

ln(1+r) =

r,

(5.5)

## The logarithmic y trend follows

trend ln y ttrend = ln y 0 + rt,

(5.6)

which is obtained by rearranging (5.5). The exponential trend is thus the same as a linear logarithmic trend: each period r is added to the previous ln y ttrend . This also implies that the trend can be graphically constructed in a logarithmic diagram by drawing a straight line between the start and end values.2 The distance between the actual values and the trend line will show the relative cyclical deviation. Thus we may directly compare the relative sizes of the cycles. The method is illustrated in Figure 5.3a.

Method 2. Fitting a trend with regression Logarithmic data.3 The trend growth rate r is the regression coefficient on time in the linear regression equation ln yt = a + r t + t ,

(5.7)

2 3

In the same way as average inflation was constructed in Figure 2.3b. We dont show how the method works with original data as in practice it is only implemented with logarithmic data. EXCEL can, however, show the trend with the original data using regression as exemplified in Figure 2.6c.

where t is time and is a so called error term, which here represents the cycle. The equation comes from adding the cycle, that is , to both sides of 5.6. ( plus ln yttrend is the actual
trend ln y t . a gives an estimate of ln y0 .) Linear regression is explained in the estimation

chapter. For now, think of it as laying a ruler on the graph to find the general upward tendency without fixing the trend to coincide with the start- and end points.

Since the method does not presume that the actual and trend values coincide at the start and at the end, it is more flexible. If the period is long, however, the result is virtually the same as with method 1. The method is illustrated in Figures 5.2c and d. EXCEL uses this method to construct the trend. Draw the series in a diagram, activate the diagram, highlight the series, and choose Insert, Trend. Choose a linear trend if you have logarithmic data, and an exponential if you have original data. Use Options to get the equation for the trend, and thereby the growth rate.

## Is the trend deterministic?

How do we know if the trend is constant (i.e. a trend-stationary process)? We have to first understand the properties of a constant trend. An important property of the deterministic trend is that the actual values never deviate far from the trend. To make a forecast, extend the trend line into the future. (You may do this in EXCEL with Options in Insert Trend.) Since cyclical deviations by definition are temporary, they dont affect the long run. From todays viewpoint, we make the forecast by first subtracting the cyclical deviation from todays actual value to get todays trend value and then successively compute future trend values.

Thus, if the trend is deterministic, we can forecast far in the future with reasonable confidence. Long-run forecasts are almost as good as short-run, since the deviations around the trend are limited and we know the trend is constant. A variable that follows a deterministic trend with temporary deviations is called a trend-stationary variable because the deviations from the trend are stationary. The process is a generalization of a stationary process. The trend values represent known future equilibrium values that GDP is constantly is drawn to. Graphically we can think of the trend line as a tilting of the constant mean for a stationary process. The stationary process is a limiting case of the trend-stationary process with the trend growth rate equal to zero.

The easy forecasting implication for the constant trend can be tested by constructing historical forecasts. We pretend that we are in a previous year and wish to forecast GDP. Imagine we are in 1980 and want to forecast GDP in 1990. We presume that the trend is constant: we estimate the trend between 1960 and 1980 and project it into 1990. Since we have data for 1990, we can check if the forecast worked: if it is far from the actual value, we reject the idea of a deterministic trend. We have done a forward-looking evaluation of the constant trend model. The method is illustrated in 5.7a.

An alternative is backward-looking evaluation. If the trend reflects permanent component of GDP, the cyclical component should follow other measures of the business cycle. Such an indicator could be unemployment. 4 Do the turning points of unemployment coincide with the turning points for the GDP cycles? If the trend has changed, this will show up as too long cycles.

Backward- and forward-looking tests of a constant deterministic trend for GDP generally fail and the model is therefore discarded for most countries.

## Deterministic trend with ARMA model of the cycle

We may wish to model the cycle as well as the trend. A simple model of the cycle is to model it as an ARMA-model. ARMA-models are used to model stationary data. If we start with measures of the cycle (actual y -trend y, detrended data), we may therefore fit an ARMA model to these data. Since the actual evolution of the variable is the sum of the trend and cyclical part, we may just add the ARMA model and the trend model.

## An estimated model may look like this:

yt = y0 + 0 .03t + 0.5 y t 1 + 0.1 y t 2 + t 0.2 t 1 , { 14444 4 244444 3 Loglinear ARMA(2,1) trend mean = 0 14 24 3 14444 4 244444 3
yttrend ytcycle

(5.8)

A cyclical indicator for the U. S. is the NBER reference cycle, (see the internet: www.nber.org).

where y is the logarithmic value of the variable. The estimation gives you values for the coefficients and estimates of all the s. (How the estimation is done has to wait.)

The model can be used for stochastic simulation. For a given starting value of y, a random draw of s and values for the coefficients (from an estimation or made up the experimenter), y can be stochastically simulated. If you wish, you can create a separate series for the trend and the cycle and then add them up.

## Segmented deterministic trend

If the trend jumps, the series is not trend-stationary. The trend may jump in different ways. Figure 5.4 illustrates a single trend jump with a) a jump in the trend line with constant growth rate, b) a change in the growth rate without a jump in the level, or c) a combination of a) and b). If we think we can see some large changes in the series, we can compute separate trend lines between the changes - a segmented trend. The changes in the trend may be due to large supply shocks, which change permanently the level and/or the growth rate. Examples are oil discoveries, natural catastrophes and big inventions, which change GDP for all future. How many breaks and where they occur, is a matter of judgment based on the series itself as well as other knowledge that indicate the presence of large supply shocks.

Where the breaks are put and of what type they are, determine the cyclical component. This implies that a given change in GDP, can be interpreted in different ways. If there is a trend break, the cycle is small, as illustrated in Figure 5.5. Since we are never sure until later if there has been a trend break, the stabilization problem is much larger than traditionally thought. A current downturn in actual GDP, for example, could be a temporary recession, which may be avoided with an expansionary policy action. Or, it could be due to a fall in the trend, in which case an expansionary policy action wont have any effect (and possibly bad effects by creating inflation.)

## Continuously changing trends

The growth rate may be postulated to continuously increase or decline. This may entail a switch between positive and negative growth rates, in which case the trend includes a minimum or maximum value. This can be modeled with a so-called quadratic trend, that is, the trend is described as a quadratic function of time: y ttrend = 0 + 1t + 2 t 2

(5.9)

where the s are fixed coefficients. The quadratic trend is fitted to the observations by regression analysis which selects the coefficients to let the trend curve be as close as possible to the observations. In EXCEL, you choose a polynomial trend of order two with the Insert Trend command after highlighting the data in a time series diagram. It can be evaluated as the constant trend with backward and forward evaluation. The backward evaluation gives rise to shorter cycles than the constant trend since the curved trend line can come closer to the data points. On that count, the quadratic trend often works better for GDP. Forward evaluation (use the forecast option in Insert Trend) is possible since the method hypothesizes that the trend is deterministic, as with the constant growth rate trend, so that the actual values never deviate too much from the trend. For GDP, a quadratic trend seldom works better for long-run forecasts than the constant trend. One reason is that sooner or latter the trend counterfactually predicts a permanent switch between positive and negative growth rates. (A quadratic function always has a minimum or maximum, which however may well be outside the estimated range.)

## The Hodrick-Prescott trend

The so-called Hodrick-Prescott trend (or filter) is today one of the most popular methods. It is also called the Wittaker-Henderson filter. The method calculates trend GDP by smoothing the fluctuations of GDP. Look at Figure 5.6 (top): it appears the Hodrick-Prescott trend could be found by running a pen through the series to smooth out the wiggles. You may think of the Hodrick-Prescott trend as a mathematical procedure to do just that, with the added benefit that it can be reproduced exactly by others. This is one important aspect of a scientific procedure.5 The method is more flexible than the quadratic trend as it allows many switches between increasing and decreasing growth rates in the trend.

The trend in y is not in this case is not described by an equation as in the previous cases. Trend y is instead found indirectly by minimizing:

## y ln y ) (ln 144 244 3

t =1 t trend t ln y cycle

+ (ln y ln y ) (ln y ln y ) 144 4 2444 3 144 4 2444 3 t =2 Trend growth t +1 Trend growth t 14444444 4 24444444 4 3
trend t +1 trend t trend t trend t 1 Trend growth

T 1

(5.10)

The expression consists of two sums. The first is the sum of squared cyclical fluctuations. The second is the sum of squared changes in the growth rate of the trend. Think of the minimization as a trial and error procedure. To get the first sum, suggest a trial series of trend values; calculate the cyclical deviations as logarithmic differences; square the differences; and sum the squares. To get the second sum, calculate the one-period growth rates as logarithmic differences; take the difference between successive growth rates; square the differences; sum the squares and you have the second sum. Suggest another trend and repeat until the expression is minimized. Table 5.1 how the minimization can be done in EXCEL. is a constant which is chosen by the researcher and determines the degree of smoothness in the trend. If is set to zero the second sum disappears. Then you minimize the first sum by simply selecting trend y to be equal to actual y, so the cyclical part disappears. In this case, the trend and actual y coincide and the trend is not smooth at all. At the other extreme, select a
5

The method is described in Robert J. Hodrick and Edward Prescott, "Postwar U.S. Business Cycles: An Empirical Investigation." Journal of Money, Credit, and Banking, 29, 1997. The method has been used since it was first presented in a working paper in 1981.

very high and the first sum loses importance. In this case, choosing a deterministic trend - a very smooth trend, minimizes the total sum. With a deterministic trend, the trend growth is constant from period to period and the second sum is zero. In this case, the cyclical portion is large. Choosing an intermediate value of , we get a compromise between a deterministic trend and a very variable trend. Thus, the larger , the smoother the trend. For quarterly data, Hodrick and Prescott recommend = 1600; for yearly data = 100 is reasonable. The method is demonstrated in Figure 5.6. Notice that the two shaded surfaces in the lower panel correspond to the two sums.

The Hodrick-Prescott filter can be calculated in a spreadsheet with the following table:

## Adjustable cells: t 1 2 et c T-1 T ln y t

ln y ttrend

(ln y )

cycle 2 t

ln y1 ln y 2

value value

(ln y )
(ln y )

cycle 2 1

[( ln y )] ( ln y )
trend t

trend 1

cycle 2 2

[( ln y )]
trend 2

ln yT 1 ln yT

value

(ln y )

cycle 2 T 1

[( ln y )]
trend T 1

:
Minimize goal cell: Note: ln y tcycle = ln y t ln y ttrend ,

100

(ln y )
T t =1 cycle t

trend + ln y 2 t =2

T 1

[(

)]

## trend ln y ttrend = ln y ttrend ln y ttrend ln y ttrend . +1 ln y t 1

) (

) (

The goal cell and adjustable cells are found in the minimization routine in Tools/Solver. Choose = 100 for yearly data, and = 1600 for quarterly data. Cells marked Value are calculated by EXCEL, but first you must supply guesses. Copy the actual values (be sure to copy only values, not formulas!). Warning: The procedure may take a considerable time with quarterly data.

Stochastic trends
Instead of sudden but few big changes with permanent effects, it is conceivable that shocks with permanent effects happen every year, but less strong on average. After all, new innovations and organizational improvements that change productivity and GDP occur all the time. The deterministic trend assumes that these come about at an equal rate every year. More realistically, the pace is uneven in which case the trend jumps every period because every period there is something slightly different happening that affects GDP for all future. Economic historians today emphasize small but numerous technical changes over the big inventions we read about in school - the introduction of the steam engine, electricity et c.

The difficulty in making long-run forecasts, together with new insights on long-run growth, has led macroeconomists to consider models of the trend that allow jumps every period - a so called stochastic trend, stochastic because the jumps are random. A stochastic trend may sound contradictory. One way of thinking of it is as the limiting case of one or few trend breaks. If there can be a single break, there can be two, three et c until there is one in every period. The idea is illustrated in Figure 5.7.

The process can be likened to a cylinder on a rough and flat surface: if the cylinder gets a kick, it changes its position permanently. If the cylinder gets a kick of stochastic size every period, it behaves like a stochastic trend. There is no resting position to which the variable always returns after a shock, as in the trend-stationary case, which behaves like the pendulum.

A stochastic GDP changes over time according to a normal growth - a deterministic portion of the trend, and shocks which add up over time. This implies that GDP is difficult to forecast, and increasingly so as the forecast horizon increases. Forecast uncertainty increases with the forecast horizon. Trend GDP in ten years time depends on ten future and unknown shocks with permanent effects, whereas trend GDP in five years time only depends on five future, unknown shocks. Since the shocks by definition are unforecastable, they may be negative or positive, the best forecast is the deterministic drift term. Thus the forecast is the same as for a deterministic trend: it is the average growth line projected into the future. The method is shown in 5.6b. The difference from the deterministic trend is that the forecasts grow more

uncertain, the longer the forecast horizon. This was actually our forward-looking test for a deterministic trend.

In a backward-looking perspective our GDP today is the sum of all permanent changes in the past. In many parts of the world, land is cultivated that was cleared thousands of years ago; we use double book-keeping invented in the 16th century; we transport goods on railways that first were built more than hundred years ago et c.

## Calculating a stochastic trend - ARIMA processes

There is no unique way to calculate a stochastic trend. Actual GDP may be divided into a trend with small jumps or a trend with large jumps. The two extreme cases are illustrated in Figure 5.8, which for the same GDP series shows two different stochastic trends. Thus, the problem of stabilization discussed with segmented trends due to a few large shocks is the same here: a given change in actual GDP may be the result of a large change in the trend or a large change in the cycle.

Variables that contain stochastic trends are obviously non-stationary. The first (logarithmic) differences are however stationary. For this reason, a variable that contains a stochastic trend is said to follow a difference-stationary process. The first differences contain both cyclical changes and trend jumps. As we shall see, it is possible to decompose the first difference in the two parts: the trend jump and the cyclical change.

We shall here look at one particular model that describes a variable that contains a stochastic trend, namely the so-called ARIMA process. An ARIMA model is a pure time series model which models the variable by describing the first differences as following a stationary ARMA process of the first differences. Given an initial value of the variable, the following evolution can be computed by successively adding the differences to the previous periods level. I in ARIMA stands somewhat confusingly for integrated, that is the opposite of differenced. The reason is that when we add up the differences (integrate), we recover the original levels. The value of y at a certain date must be equal to the value of y at some initial level plus the sum of the intervening first differences since that initial date.

We will study ARMA models for first differences, so called ARIMA(n,1,m), where the middle index stands for the order of difference, that is in our case 1. An ARIMA(1,1,1) model has this form: yt = 0 + 1yt 1 + t + t 1 .

(5.11)

The equation has the same form as an ARMA(1,1), except that we have placed a before each y, that is, we have taken first differences. For macroeconomic time series, first differences are almost exclusively used. We assume that the variable is difference-stationary.

Suppose a certain ARIMA model has been estimated. We now want to investigate its implications by using our two tools: impulse response analysis and stochastic simulation. Since an ARIMA model is an ARMA model of first differences, we already know how the first differences behave. The question is: How do the levels behave? Rewrite the ARIMA model in level form by writing out the first differences in (5.11): yt yt 1 = 0 + 1 ( yt 1 yt 2 ) + t + t 1,

## move y t 1 to the right-hand side and rearrange

yt = 0 + (1 + 1 ) yt 1 1 yt 2 + t + t 1 .

(5.12)

This is an ARMA(2,1) equation. Note that when 1 is between 0 and 1, the first differences ar stationary. (Recall that a variable is stationary if the impulse response is stable. Plotting the time series of the first difference show the series wiggling around a constant mean.) But: the level of y will be non-stationary, since the coefficient on the lagged y-value (1+ 1) is greater than zero.

The basic property of an ARIMA process is that shocks have permanent effects on the level of y. The effect does not die away as in the stationary ARMA cases. In other words, its impulse graph, or dynamic multipliers dont go to zero. Let us investigate the simplest process, namely an ARIMA(0,1,0). This is a so called random walk with drift which often crops up in macroeconomic and financial models. The efficient market theory for example says that stock

prices behave as a random walk. A pure random walk has no cyclical component at all. We can think of the random walk as a model of the trend portion of a variable, or as the complete description of a variable that does not contain any cyclical component.

The ARIMA(0,1,0) says that the change in the variable is equal to a constant (the drift) and a random shock:

yt = yt yt 1 = 0 + t .

## Move y t 1 to the right-hand side to get the equation in level form

yt = yt 1 + 0 + t .

(5.13)

The current value of the variable is equal to the previous value plus a constant and plus a random shock. The shock has a permanent effect on y because it affects y with a coefficient of one.6 We can also see that with impulse response analysis. Start the process at time one and give the process a unit shock:

y1 = 0 + y0 + 1 = 0 + y0 + 1 ,

## and the next period

y2 = 0 + y1 + 1 = 2 0 + y0 + 1 + 0 ,

## and after t periods

yt = t 0 + y 0 + 1 .

(5.14)

The unit shock has a permanent effect of one. Figure 5.9a shows the impulse response graph. Note that the drift term is added each period. If there were no shocks, y increases by the number of periods times the drift from an initial value

## For this reason, the process is said to contain a unit root.

Moving to stochastic simulation of the random walk, with shocks every period, we can generalize (5.14) to

yt = t 0 + y0 + .
i=0

(5.15)

Between time zero and time t, there are t shocks which are summed since they have permanent effects. If there is a constant drift every period of 0 , the total change between time zero and t due to drift is t 0 . This term can thought of as a deterministic trend part; if there were no shocks, y just increases with the drift 0 every period. Figure 5.9b illustrates the change in y.

Lets investigate the impulse response of an ARIMA(0,1,1) process in the same way:
y t = y t y t 1 = t + t 1 ,

where the drift is set to zero. This is a random walk with a lagged shock added. Move y t 1 to the right-hand side to get the equation in level form:
y t = y t 1 + t + t 1 .

Start the process at time one and give the process a unit shock:
y1 = y 0 + 1 + 0 = y 0 + 1 + 0 .

(The shock in the previous period is set to zero.) Go on to the next period
y 2 = y1 + 2 + 1 = y 0 + 1 + 0 + 1 ,

## and after t periods

yt = y0 + 1 + .

The unit shock has a permanent effect of 1 + . The immediate effect is one in period one. If

is positive, the permanent effect is larger than the immediate effect. The difference between
the immediate and the permanent effect, that is - , is the temporary or cyclical effect. Conversely, if is negative, the temporary effect is larger than the permanent effect. The impulse response graph for the level of y for an ARIMA(0,1,1) - or more simply IMA(1) - process with a negative is shown in Figure 4.10a. The impulse response graph for the corresponding first difference, an MA(1)-process, is shown in Figure 5.10b. The effect on the change is completely temporary as seen in panel b, but leaves a permanent legacy for the level as seen in panel a.

A general expression for the permanent effect for all ARIMA processes up to ARIMA(2,1,2) is the following:

y 1 + 1 + 2 = , 0 1 1 2

(5.16)

according to the notation in Table 4.1. It is sometimes called the Campbell-Mankiw measure.7 By setting the appropriate coefficients to zero, all the special cases can be computed. For example, if all the coefficients are zero, we have the random walk with a permanent effect of one, as we showed above. For the ARIMA(0,1,1), the effect is 1 + 1 . An example of an ARIMA(1,1,1) process is shown in Figure 5.11.

J. Campbell and G. Mankiw "Are Output Fluctuations Transitory?" Quarterly Journal of Economics 102, 1987, 857-880.

The Beveridge-Nelson method for decomposing a variable into a stochastic trend and a cycle
One use of ARIMA models is to divide a variable into a stochastic trend and a cycle. In this section, we describe how that division can be done with the so-called Beveridge-Nelson method. It should be noted that, though a common method, this is not the only method to construct a stochastic trend. Recall that the presence of a stochastic trend as such, does not say anything about the importance of trend fluctuations for actual fluctuations. (See Figure 5.7.) Using the Beveridge-Nelson method we can answer this question.

In an ARIMA model there is only one type of shock, which has both temporary and permanent effects. The permanent effect is the change in the trend. Thus if the permanent effect is large relative to the temporary effect, the stochastic trend explains a large portion of the actual fluctuations of GDP. One measure of the importance of the stochastic trend is then simply the Campbell-Mankiw measure (5.16) of the permanent effect. With the help of the Campbell-Mankiw measure the stochastic trend can be calculated.8 The basic idea is simple. The trend represents the permanent part of GDP. When we calculate a deterministic trend, we increase the previous trend value with the growth rate each period. If the trend is stochastic, we must add the permanent effect of new shocks, that is the jumps in the trend line. Looking backward, the trend value is the sum of all previous jumps in the trend plus the deterministic drift part as illustrated in Figure 5.9b.

S. Beveridge and C. Nelson, 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 7, 151-74.

## Step 1. Estimate an ARIMA model, for example an ARIMA(1,1,1): y t = 0 + 1y t 1 + t + t 1 ,

(5.17)

to determine the coefficients and the s. You can do that with a standard econometrics package or you can use a published ARIMA model.10

Step 2. Calculate the change in the trend when there are no shocks. This is the normal change in y - the drift. Set the s to 0 in (5.17) and calculate the steady-state change in y (drop the time index on y):

y = 0 + 1y y =

0 1 1

Step 3. Calculate the permanent effects of the shocks by multiplying the s with CampbellMankiws measure (5.16) and add the drift to get the total change in the trend:

yttrend =

0 1+ t + 1 1 1 1

Step 4. Calculate y trend from a starting point when y trend is assumed known, by successively adding the change in the trend to the previous trend value:11
trend y ttrend = yttrend 1 + y t

The method is adopted from John T. Cuddington and L. Alan Winters, "The Beveridge-Nelson Decomposition: A Quick Computational Method, Journal of Monetary Economics 19, 125-128. 10 If you use an ARIMA model estimated by somebody else, you can calculate the s. Rearrange (4.42) to get

t = yt 0 1yt 1 t 1
Since t refers back to in the previous period, you must start by choosing an initial value for ; choose zero. Then you can successively calculate the shocks. Over time, the choice of the initial decreases in importance.
11

Alternatively,

## trend trend + yitrend = y 0 + y ttrend = y 0 i =1

0 1+ t t + i . 1 1 1 1 i =1

## The procedure is summarized in Table 5.2.

Table 5.2. Decomposition of actual y into a stochastic trend and a cyclical component for an ARIMA(1,1,1) model with known coefficients. t 0 1 2 et c. Note: Start at a value when actual and trend-GDP coincide. To compute trend-values before that, apply the procedure backwards in time by subtracting the trend jumps from the starting value.

yt y0

yttrend

yttrend
y0

y tcycle 0
y1 y1trend
trend y2 y2

1 2

y1 y2

0 1+ + 1 1 1 1 1 0 1+ + 2 1 1 1 1

y 0 + y1trend
trend y1 + y 2

The advantage of the Beveridge-Nelson method is that it gives empirical estimates of the stochastic trend. This is useful in many connections beyond the decomposition as such into a trend and a cycle component. The permanent income theory of consumption, for example, says that only unexpected permanent changes in GDP, that is jumps in the trend, affect consumption. The hypothesis may be tested by regressing consumption on the trend jumps with an expected coefficient of one.

The disadvantage of the Beveridge-Nelson method is that it lumps all kinds of shocks into one. Standard macroeconomic theory, however, says that there are different types of shocks. Aggregate demand shocks have primarily temporary effects, and aggregate supply shocks permanent effects. Only if these shocks occur together with the same relative strength and direction is the procedure warranted. An alternative to ARIMA, which also contains a stochastic trend, is to assume that there are two types of shocks: those with only temporary

effects and those with only permanent effects, which are independent. Such a model will result in less variation in the stochastic trend and hence attribute a larger portion of actual fluctuations to cycles. These models are called Unobserved Components time series models. Figure 5.7b illustrates a decomposition with such a model which may be contrasted to the decomposition from an ARIMA model given in Figure 5.7a.

## Conclusion and a suggested strategy for determining the trend model

There is considerable agreement today that the trend is not deterministic for most macroeconomic time series. Simply put, there are shocks which have permanent effects. One implication is that forecasts become less reliable the farther into the future they reach. History is full of failed long-term forecasts. A famous example is Chrustjevs prediction in the early 1960s that the Soviet Union would surpass the United States in living standards by the early 1970s, which he based on the growth rates of the 1950s. For the same reason, we cannot accurately determine the trend back in time. Since we cannot forecast far in the future, we do not know with certainty the permanent effects of past changes and hence we cannot definitely determine the trend and the cycle for the observed GDP series.

Figure 5.12 summarizes the methods in the form of a step-wise investigation. All analysis of economic time series should first determine if the variable contains a trend or not, that is, if it is stationary or non-stationary. If we arrive at the non-deterministic trend stage, it is often difficult to choose between the alternatives. While there are statistical tests that can help to distinguish between the alternatives, the answers are seldom clear-cut. If in doubt, choose the Hodrick-Prescott filter.

Exercises

## 1. Which variables are stationary?

Plot the time series for real GDP, real GDP growth, real interest rates, and unemployment since 1950 in separate diagrams. Also plot their averages. (Calculate the average and make it a series in the spreadsheet. Use absolute reference.) Are any of them stationary? If so, comment on their speed of adjustment towards the mean. What are your long-run predictions for the stationary variables? If your country has indexed bonds, do you have any advice to a long-term investor?

## 2. Exponential GDP trend: backward-looking evaluation

Make a diagram of real lnGDP over time and one linear trend 1960 until today. Find the turning dates when lnGDP crosses the trend line. Make another plot of relative unemployment (original value) over time and its linear trend line (if it is stationary, the trend line will have almost zero slope). Find the turning points when unemployment crosses the trend line. Do the two ways of dating the business cycle agree? Are the lengths of the business cycle similar? Which measure do you think best captures the business cycle? Is a constant exponential trend for GDP a reasonable trend model?

## 3. Exponential GDP trend: forward-looking evaluation

Draw a diagram of real lnGDP from 1950 until today. Suppose you are at the beginning of 1971 and you make a forecast for 1980 based on the linear trend 1950-1970, how good will your forecast turn out to be? How good is a forecast for 1990 made in 1971?12 How big are the relative forecast errors measured as (forecast-actual)/actual? Is a constant exponential trend a reasonable assumption? Ask your parents how much they thought their income would
12

To be able to do a forecast based only on the trend for 1950-70 with EXCELs Insert Trend command, while still showing the actual development after 1970, you have to trick EXCEL by drawing GDP for 1950-70 and 1971-today as separate series.

increase from 1970 to 1990 and how confident they felt about this? Did they assume an exponential trend? Was their income in 1990 a surprise relative to what they expected in 1970? How would you make a forecast for the next twenty years, and what confidence would you put in it?

## 4. The Hodrick-Prescott filter

Plot yearly, actual real lnGDP, and trend lnGDP 1950 until today according to the HodrickPrescott filter. Calculate the cyclical part and multiply by 100 to get it in percentage deviations from the trend and plot it in another diagram. Plot in the same diagram the deviation of unemployment from its trend - another measure of the cycle. Can you by experimenting with different s make the two cyclical series crossings of the zero line coincide? Do the diagram first for =100; then experiment by looking in the diagram. (You may have to change a lot to get any perceptible changes.) Does the Hodrick-Prescott filter result in a reasonable cycle?

## 5. Is there a constant natural unemployment rate?

Plot unemployment for four countries in your neighborhood 1970-1990 and their averages. Make sure the diagrams have the same vertical scales. In which countries is unemployment approximately stationary? In case they are, we may identify the mean as a constant natural rate of unemployment. If they are not stationary, are they trend-stationary? In case they are, long-run unemployment would be predictable and could be described by the constant trend. Use a forward-looking test (as described in the text and exercise 5.6.) If they are not trendstationary, it is an indication of so called hysteresis.13 This term is often used to describe a stochastic trend in unemployment. You may think of it is an absence of a natural rate. Do you find evidence of hysteresis in any of the countries?

13

## Hysteresis is further discussed in chapter 3.3.

Estimate an AR(1) model for the change in lnGDP, that is, estimate
y t = 0 + 1 y t 1 + t

where y is lnGDP, with simple regression (regard y t 1 as an x-variable). Draw the impulse response graph for the change in GDP. Draw another impulse response graph for the level of GDP. Mark also in this diagram the permanent effect of the shock according to the CampbellMankiws measure. Comment on the speed of adjustment. Optional: Make a stochastic simulation of the level of GDP (say over 30 periods) and compare with the actual GDP series. (Convert the change form to level form first.) Do they look similar?

7. Decomposition of GDP into a stochastic trend and a cycle (dynamic stochastic simulation)

Use an estimated AR(1) model of the change in real GDP to decompose GDP into a stochastic trend and a cycle according to Table 5.2. Make a diagram with actual GDP and the stochastic trend. Draw another diagram with the cyclical portion and an estimate of cyclical unemployment (subtract a linear trend from the unemployment rate). Do the peaks and troughs of the two measures of the cycle coincide approximately? What is your conclusion.

## 8. Are forward-looking tests for trend-stationarity reliable? (dynamic stochastic simulation)

Simulate lnGDP as composed of a deterministic trend and a cyclical part modeled as an AR(1)-process: yt = y 0 + 0.03t + 1 yt 1 + t . 1 4 24 3 14 24 3
trend cycle

Create three simulated series for 60 periods with 1 set to 0.2, 0.8, and 0.95. Try the forwardlooking test for trend-stationarity by making historical projections from the trend estimated for the first 40 periods. Here we know that the series is trend-stationary because we constructed it so. May it still be possible to question that the series is trend-stationarity? Why?