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The Relative Importance of Permanent and Transitory Components: Identification and Some Theoretical Bounds

Danny Quah

Abstract

Much macroeconometric discussion has recently emphasized the economic significance of the size of the permanent component in GNP. Consequently, a large literature has developed that tries to estimate this magnitude--measured, essentially, as the spectral density of increments in GNP at frequency zero. This paper shows that unless the permanent component is a random walk this attention has been misplaced: in general, that quantity does not identify the magnitude of the permanent component. Further, by developing bounds on reasonable measures of this magnitude, the paper shows that a random walk specification is biased towards establishing the permanent component as important.