Permanent vs Transitory Components and Economic Fundamentals

Authors:
  • AGAnthony Garratt
    Anthony Garratt
  • DRDonald Robertson
    Donald Robertson
  • SWStephen Wright
    Stephen Wright
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  • 1 January 2005
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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