Transitory Innovations Research Articles

Exchange Rate Risk and Business Cycles

We show that currencies with a steeper yield curve tend to depreciate at business cycle horizons, in violation of uncovered interest parity. The yield curve adds no explanatory power over and above spot yield differentials in explaining exchange rates at longer horizons. Analysing bond holding period returns, we identify a tent-shaped relationship between the exchange rate risk premium and the relative slope across horizons. We derive this relationship analytically within an asset pricing framework and show it is driven by differences in transitory innovations to investors’ stochastic discount factor, captured by the relative yield curve slope and consistent with business cycle risk. Our mechanism is robust to the inclusion of liquidity yields, which instead contribute to explaining cross-sectional differences across currencies and reflect permanent innovations to investors’ stochastic discount factor.

Frequency Dependence in a Real-Time Monetary Policy Rule

We estimate a monetary policy rule for the US allowing for possible frequency dependence -- i.e., allowing the central bank to respond differently to more persistent innovations than to more transitory innovations, in both the unemployment rate and the inflation rate. Our estimation method uses real-time data in these rates -- as did the FOMC -- and requires no a priori assumptions on the pattern of frequency dependence or on the nature of the processes generating either the data or the natural rate of unemployment. Unlike other approaches, our estimation method allows for possible feedback in the relationship. Our results convincingly reject linearity in the monetary policy rule, in the sense that we find strong evidence for frequency dependence in the key coefficients of the central bank's policy rule: i.e., the central bank's federal funds rate response to a fluctuation in either the unemployment or the inflation rate depended strongly on the persistence of this fluctuation in the recently observed (real-time) data. These results also provide useful insights into how the central bank's monetary policy rule has varied between the Martin-Burns-Miller and the Volcker-Greenspan time periods.

TREND IN CYCLE OR CYCLE IN TREND? NEW STRUCTURAL IDENTIFICATIONS FOR UNOBSERVED-COMPONENTS MODELS OF U.S. REAL GDP

A well-documented property of the Beveridge–Nelson trend–cycle decomposition is the perfect negative correlation between trend and cycle innovations. We show how this may be consistent with a structural model where permanent innovations enter the cycle or transitory innovations enter the trend, and that identification restrictions are necessary to make this structural distinction. A reduced-form unrestricted version is compatible with either option, but cannot distinguish which is relevant. We discuss economic interpretations and implications using U.S. real GDP data.

Intergenerational Earnings Mobility Revisited: Estimates Based on Lifetime Earnings*

AbstractUsing Norwegian intergenerational data, which include a substantial part of the life‐cycle earnings for children and almost the entire life‐cycle earnings for their fathers, we present new estimates of intergenerational mobility. Extending the length of fathers’ earnings window from 5 to 25 years increases estimated elasticities. Increasing the age at which fathers’ earnings are observed has the opposite effect. Biases in the estimated elasticities are related to both transitory earnings variation and life‐cycle measurement error; the former appear to be more important than the latter. Estimation bias stemming from persistence in transitory innovations plays only a minor role. Our findings indicate that intergenerational earnings mobility in Norway might have been strongly overstated in many earlier studies with shorter earnings histories. Some of our new estimates are twice as large as earlier estimates.

Asymmetry in the Business Cycle: Friedman's Plucking Model with Correlated Innovations

This paper develops an unobserved components model for U.S. real GDP that allows for both asymmetric transitory movements and correlation between the permanent and transitory innovations. The asymmetry is modeled using Markov-switching in the transitory component in the spirit of Kim and Nelson’s (1999) version of Friedman’s plucking model. The findings suggest that ignoring the correlation between permanent and transitory movements underestimates the role of permanent movements, whereas ignoring asymmetry in the transitory component underestimates the role of temporary movements in U.S. real GDP. These results imply that both permanent movements and asymmetric transitory shocks are important for explaining post-war output fluctuations in the U.S. and for explaining the recession that began in 2007 in particular.

The Buffer Stock Model Redux? An Analysis of the Dynamics of Foreign Reserve Accumulation

Emerging market economies have recently accumulated large stocks of foreign reserves. In this paper we address the question of what are the main factors explaining reserve holdings in nine developing countries located in Asia and Latin America. Monthly data from January 1985 to May 2006 are used to estimate for each country the long run equilibrium reserve demand, based on the buffer stock model, the short run dynamics governing the process of reserve accumulation (decumulation) and the factors which may influence the speed of adjustment of actual to desired reserves. Cointegration analysis suggests that the buffer stock precautionary model explains the optimal reserve demand reasonably well. The corresponding VECMs are further interpolated, using the permanent and transitory innovations decomposition procedure of Gonzalo and Ng (2001), in order to assess the relative impact of the time series to the convergence to equilibrium after a shock. Finally the (asymmetric) effect on the speed of convergence of positive/negative changes in signal variables - such as the excess reserves of the previous period, relative competitiveness and US monetary stance - is found to be significant, in ine with mercantilistic and fear of floating motives to hoard international reserves.

Estimates of Intergenerational Elasticities Based on Lifetime Earnings

Using Norwegian intergenerational data with a substantial part of the life-cycle earnings of children and almost the entire life-cycle earnings for their fathers, we present new estimates of intergenerational mobility. Extending the length of the fathers' earnings windows from 5 to 30 years increases the estimated elasticities. Increasing the age of father at observation has the opposite effect. Our findings indicate that intergenerational earnings mobility may have been strongly overstated in many earlier studies with shorter earnings histories. Biases in the estimated elasticities appear to be related to age and/or life-cycle measurement errors more than persistency in the transitory innovations.

The role of permanent and transitory shocks in explaining international health expenditures

While there is a growing literature that examines the issue of cointegration (co-movement over the long run) among health expenditures, there are no studies that examine the issue of common cycles (co-movement over the short run) among health expenditures. We undertake a multivariate variance decomposition analysis of per capita health expenditures of the USA, the UK, Japan, Canada, and Switzerland based on a common-trend-common-cycle restriction framework, to examine the relative importance of permanent and transitory innovations in explaining variations in per capita health expenditures in each of the five countries. Our main finding is that transitory shocks are more important in explaining per capita health expenditures in the UK, Japan, and Switzerland, while permanent shocks dominate variations in per capita health expenditures in the USA and Canada over short horizons.

Reexamining the permanent income hypothesis with uncertainty in permanent and transitory innovation states

In this paper, we reexamine the permanent income–consumption relationship analytically and empirically, based on the innovation regime-switching (IRS) model developed in [Kuan, C.M., Huang, Y.L., Tsay, R.S., 2005. An unobserved component model with switching permanent and transitory innovations. Journal of Business and Economic Statistics, 23, 443–454]. A novel feature of the IRS model is that it explicitly allows for uncertainty in innovation states. When the labor income follows an IRS process, it is shown that the agent’s perception on the likelihoods of income innovations being permanent and transitory plays a crucial role in determining the optimal forecasts on the change of consumption. The effect of a current labor income innovation on consumption is a weighted average of two distinct effects resulting from permanent and transitory innovations with the weights equal to the perceived likelihoods of the respective states. Also, past innovations may affect consumption when there are revisions in the perceived likelihoods of previous states. Our empirical study on US data shows that consumption indeed reacts significantly to the perceived likelihoods of innovation states. However, even after controlling for the effect of state uncertainty, we find consumption vastly underreacts to permanent innovations in labor income but reacts about the right magnitude to transitory ones when compared with the prediction of the permanent income hypothesis. This evidence is similar to [Elwood, S.K., 1998. Testing for excess sensitivity in consumption: A state-space unobserved components approach. Journal of Money, Credit, and Banking, 30, 64–82] but in sharp contrast with that found in [Hall, R.E., Mishkin, F.S., 1982. The sensitivity of consumption to transitory income: Estimates from panel data on households. Econometrica, 50, 461–480].

Asymmetry in the Business Cycle: Friedman's Plucking Model with Correlated Innovations

Recent research has shown that unobserved components (UC) models can, under certain conditions, be estimated without imposing the common zero-correlation restriction between the permanent and transitory innovations. Estimates applying this model to US real GDP suggest that US output experiences considerable permanent movements. This result is in stark contrast to the findings based on estimates of zero-correlation models which suggest that fluctuations in output are primarily transitory. If the transitory component of US real GDP is asymmetric, particularly during recessions, then the linear UC model may over-emphasize permanent movements due to the dominance of expansions in the data. This paper produces and estimates an unobserved components model that allows for asymmetric transitory movements and for correlation between all the innovations. The asymmetry is modeled using Markov-switching in the transitory component, in the spirit of Kim and Nelson's (1999) version of Friedman's plucking model. The findings suggest that both permanent movements and asymmetric transitory shocks are important for explaining post-war output fluctuations in the U.S.

An Unobserved-Component Model With Switching Permanent and Transitory Innovations

This article proposes an unobserved-component model in which component innovations are governed by a state variable that follows a Markov process. The proposed model is capable of describing both stationary and nonstationary behaviors of real data and allows the random innovations to have permanent and transitory effects in different periods. The model also permits a deterministic trend with or without breaks and hence bridges the gap between the trend-stationary model and a random walk with drift. For ease in presentation and in application, our discussion focuses on the model consisting of a random-walk component and a stationary autoregressive moving average component. However, the proposed model is much more flexible. We investigate properties of the proposed model and derive an estimation algorithm. We also propose a simulation-based test to distinguish between the proposed model and an autoregressive integrated moving average model. For application, we apply the model to U.S. quarterly real gross domestic product and find that unit-root nonstationarity is likely to be the prevailing dynamic pattern in more than 80% of the sample periods. Because nonstationarity (stationarity) periods match the National Bureau of Economic Research dating of expansions (recessions) closely, our result suggests that the innovations in expansion (recession) are more likely to have a permanent (transitory) effect.

The common-trend and transitory dynamics in real exchange rate fluctuations

This study examines the behaviour of both Common Trend (CT) and transitory components of Real Exchange Rate (RER) fluctuations under the current float. The CT component is in most cases found to be sizeable, albeit its relative importance can vary considerably across major currencies and its estimate can be sensitive to whether or not long-run Purchasing Power Parity (PPP) is imposed on the data. Further analysis suggests that both CT and transitory innovations are linked much more to interest rate changes than to productivity changes. Accordingly, it is interest rate, not productivity, disturbances that drive the highly persistent RER.

Measuring Monetary Policy in Germany: A Structural Vector Error Correction Approach

AbstractA structural vector error correction (SVEC) model is used to investigate several monetary policy issues. While being data-oriented the SVEC framework allows structural modeling of the short-run and long-run properties of the data. The statistical model is estimated with monthly German data for 1975-98 where a structural break is detected in 1984. After splitting the sample, three stable long-run relations are found in each subsample which can be interpreted in terms of a moneydemand equation, a policy rule and a relation for real output, respectively. Since the cointegration restrictions imply a particular shape of the long-run covariance matrix this information can be used to distinguish between permanent and transitory innovations in the estimated system. Additional restrictions are introduced to identify a monetary policy shock.

Understanding Trend and Cycle in Asset Values: Reevaluating the Wealth Effect on Consumption

Both textbook economics and common sense teach us that the value of household wealth should be related to consumer spending. At the same time, movements in asset values often seem disassociated with important movements in consumer spending, as episodes such as the 1987 stock market crash and the contraction in equity values that occurred in the fall of 1998 suggest. An important first step in understanding the consumption-wealth linkage is determining how closely the two variables are actually correlated, and whether there exist important movements in asset values that are not associated with changes in consumption. This paper provides evidence that a surprisingly small fraction of the variation in household net worth is related to variation in aggregate consumer spending. We use empirical techniques that allow us to quantify the relative importance of permanent and transitory innovations in the variation of consumer spending and wealth and find that transitory shocks dominate post-war variation in wealth, while permanent shocks dominate variation in aggregate consumption. Although transitory innovations are found to have little influence on consumer spending, they have long-lasting effects on wealth , exhibiting a half-life of a little over two years. The findings suggest that most macro models which make no allowance for transitory variation in wealth that is orthogonal to consumption are likely to misstate both the timing and magnitude of the consumption-wealth linkage.(This abstract was borrowed from another version of this item.)

Productivity Shocks, Monetary Shocks, and the Short- and Long-run Dynamics of Exchange Rates and Relative Prices

This study evaluates the individual roles of monetary and productivity shocks in real exchange rate fluctuations under the current float. Using a cointegration model of exchange rates and relative prices, the innovations are decomposed into transitory and common-trend parts. Both transitory and common-trend innovations are found to explain a significant portion of real exchange rate fluctuations, albeit their relative importance can vary across major currencies. Further analysis suggests that common-trend innovations are ascribed mostly to productivity shocks, whereas transitory innovations are governed by monetary shocks. The allowance for productivity shocks, however, appears insufficient to fully explain the high persistence of real exchange rates.

Calculation of aggregate demand and supply disturbances from a common trends model

The paper shows how to calculate permanent and transitory innovations à la Blanchard and Quah (American Economic Review, 79 (1989) 655–673) from a cointegrated VAR model. This is important for two reasons: first, it clarifies the relation between the two decompositions (they are equivalent) and second, it simplifies the procedure of actually computing the structural innovations.

Identification, Long-Run Relations, and Fundamental Innovations in a Simple Cointegrated System

This paper examines the roles played by innovations identified from a simple four-variable VAR characterized by cointegration. Using knowledge of cointegration rank and “textbook” relations that link macroeconomic aggregates, we identify distinct “real” and “nominal” innovations that dictate the long-run behavior of the model. We also examine the explanatory power of transitory innovations that are orthogonal to these permanent shocks. One of the permanent shocks displays all the characteristics of a technology or “supply” innovation, while one of the transitory innovations—identified by imposing short-run price rigid-ity—is interpretable as a “demand” side impulse. The permanent nominal shock bears the imprint of an innovation in aggregate inflation expectations. Historical decomposition and comparison with variables that are external to the model reveals the relative importance of the shocks at various episodes.

Capital adjustment costs, time-to-build effects, and inflation nonneutrality

The paper examines how the presence of capital adjustment costs and time-to-build constraints weaken the Fisher effect and inflation neutrality, and hence attenuate the arbitrage opportunities implicit in intertemporal substitution and the investment decision. It is demonstrated that large and permanent changes in inflation affect nominal interest rates, intertemporal substitution, and investment choices differently than small or temporary changes. Small, transitory inflationary innovations will lower real interest rates, yet create no arbitrage opportunities since the benefits from these low rates will be insufficient relative to the adjustment costs implicit in altering investment. Large, permanent inflationary innovations will possess no real effects. The paper then presents empirical work to support the prediction that the expected inflation effect on nominal interest rates depends on the perceived size and permanence of the innovation.