Common cycles and the importance of transitory shocks to macroeconomic aggregates

Abstract

Although there has been substantial research using long-run co-movement (cointegration) restrictions in the empirical macroeconomics literature, little or no work has been done investigating the existence of short-run co-movement (common cycles) restrictions and discussing their implications. In this paper we first investigate the existence of common cycles in a aggregate data set comprising per-capita output, consumption, and investment. Later we discuss their usefulness in measuring the relative importance of transitory shocks. We show that, taking into account common-cycle restrictions, transitory shocks are more important than previously thought at business-cycle horizons. The central argument relies on efficiency gains from imposing these short-run restrictions on the estimation of the dynamic model. Finally, we discuss how the evidence here and elsewhere can be interpreted to support the view that nominal shocks may be important in the short run.