m

How Big Is the Random Walk in GNP? John H. Cochrane The Journal of Political Economy, Volume 96, Issue 5 (Oct., 1988), 893-920.
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How Big Is the Random Walk in GNP?

John H. Cochrane
University of Chicago

T h i s paper presents a measure o f the persistence o f fluctuations i n G N P based o n the variance o f its long differences. T h a t measure finds little long-term persistence i n GNP. Previous research o n this question f o u n d a great deal o f persistence i n GNP, suggesting m o d els such as a r a n d o m walk. A reconciliation o f this paper's results w i t h previous research shows that conventional criteria for timeseries model b u i l d i n g can produce misleading estimates o f persistence.

I.

Introduction

M a c r o e c o n o m i s t s o n c e v i e w e d fluctuations i n gross n a t i o n a l p r o d u c t as t e m p o r a r y d e v i a t i o n s f r o m a t r e n d . T h e e c o n o m i c t h e o r y o f b u s i ness cycles d e s c r i b e d t e m p o r a r y d e v i a t i o n s f r o m " p o t e n t i a l G N P , " w h i c h was a s s u m e d t o e v o l v e s m o o t h l y o v e r t i m e , a n d d a t a w e r e r o u t i n e l y d e t r e n d e d p r i o r t o analysis. A b o d y o f r e c e n t e m p i r i c a l w o r k ( d e s c r i b e d b e l o w ) has q u e s t i o n e d t h i s t i m e - h o n o r e d v i e w . B y u s i n g a v a r i e t y o f time-series m o d e l s , i t finds t h a t fluctuations i n G N P are p e r m a n e n t t h a t a d e c l i n e i n G N P t o d a y l o w e r s forecasts o f G N P into the infinite future. T h i s p a p e r reexamines the l o n g - r u n properties o f G N P a n d argues t h a t G N P does, i n fact, r e v e r t t o w a r d a " t r e n d " f o l l o w i n g a shock. H o w e v e r , that reversion occurs over a t i m e h o r i z o n characteristic o f business cyclesseveral years at least. T h e r e f o r e , t h e s h o r t - r u n p r o p erties o f G N P are c o n s i s t e n t w i t h a m o d e l w i t h v e r y p e r s i s t e n t shocks,
I thank Eugene Fama, Lars Hansen, J o h n Huizinga, Robert Lucas, James Stock, Robert Shiller, an anonymous referee, and the editors of this Journal for many helpful comments and suggestions.
[Journal of Political Economy, 1988, vol. 96, no. 5] 1988 by T h e University of Chicago. A l l rights reserved. 0022-3808/88/9605-0003$01.50

893

94

JOURNAL OF P O L I T I C A L ECONOMY

a n d o n e c a n i n c o r r e c t l y i n f e r a g r e a t d e a l o f l o n g - h o r i z o n persistence by f i t t i n g a time-series m o d e l t o this s h o r t - r u n b e h a v i o r . T h e class o f time-series m o d e l m o s t c o m m o n l y u s e d t o describe t e m p o r a r y d e v i a t i o n s a b o u t t r e n d is

o o

yt =

b t

+ X

a e

j t-

(1)

7= 0

w h e r e y stands f o r l o g G N P , bt describes t h e t r e n d , a n d e is a r a n d o m d i s t u r b a n c e . F l u c t u a t i o n s iny are t e m p o r a r y i f ^ - is a s t a t i o n a r y stochastic process (y is t h e n c a l l e d " t r e n d s t a t i o n a r y " ) . F o r Xaje -j to be s t a t i o n a r y , t h e aj m u s t a p p r o a c h z e r o f o r l a r g e j . A s a r e s u l t , a d e c l i n e i n G N P b e l o w t r e n d t o d a y has n o effect o n forecasts o f t h e level o f G N P , E (y ), i n the far future, and it implies that g r o w t h rates o f G N P m u s t rise above t h e i r h i s t o r i c a l a v e r a g e f o r a f e w p e r i o d s u n t i l t h e t r e n d l i n e is r e e s t a b l i s h e d .
t t 1 t t t t t+J

T h e s i m p l e s t time-series m o d e l t h a t c a p t u r e s p e r m a n e n t t i o n s i n G N P is a r a n d o m w a l k w i t h d r i f t : y =
t

fluctua

(2)

F l u c t u a t i o n s i n a r a n d o m w a l k are p e r m a n e n t i n t h e f o l l o w i n g sense: s u p p o s e t h a t e = - 1, so t h a t y falls o n e u n i t b e l o w last p e r i o d ' s e x p e c t e d v a l u e . T h e n , since y +j y + j\x, + e , + . . . + e +j, forecasts E {y +j) f a l l b y o n e u n i t f o r t h e i n d e f i n i t e f u t u r e . A l s o , a l o w o r n e g a t i v e g r o w t h r a t e t o d a y i m p l i e s n o t h i n g a b o u t g r o w t h rates i n t h e f u t u r e , a n d t h e r e is n o t e n d e n c y f o r f u t u r e levels o f G N P t o r e v e r t t o a t r e n d l i n e . T h e r a n d o m w a l k is also n o n s t a t i o n a r y .
t t t t + 1 t t t

T h e d i s t i n c t i o n b e t w e e n a r a n d o m w a l k (2) a n d a t r e n d - s t a t i o n a r y series (1) is e x t r e m e . L o n g - r a n g e forecasts o f a r a n d o m w a l k m o v e o n e f o r o n e w i t h shocks at each date, w h i l e l o n g - r a n g e forecasts o f a t r e n d - s t a t i o n a r y series d o n o t c h a n g e at a l l . T h e r e are t w o r e l a t e d ways t o t h i n k a b o u t a series t h a t lies b e t w e e n these t w o e x t r e m e s . First, o n e c a n ask h o w m u c h l o n g - t e r m forecasts r e s p o n d t o shocks. I n o n e i n t e r p r e t a t i o n , t h e m e a s u r e o f t h i s p a p e r asks t h e q u e s t i o n , H o w m u c h does a o n e - u n i t s h o c k t o G N P affect forecasts i n t h e f a r f u t u r e ? I f b y o n e u n i t , i t finds a r a n d o m w a l k ; i f b y z e r o , i t finds a t r e n d - s t a t i o n a r y process l i k e ( 1 ) . I t c a n also find n u m b e r s b e t w e e n z e r o a n d o n e , c h a r a c t e r i z i n g a series t h a t r e t u r n s t o w a r d a " t r e n d " i n t h e f a r f u t u r e , b u t does n o t get a l l t h e w a y t h e r e , o r i t c a n find a n u m b e r g r e a t e r t h a n o n e , c h a r a c t e r i z i n g a series t h a t w i l l c o n t i n u e t o
Simple univariate time-series models like ( 1 ) should be thought of as a way of capturing the dynamic behavior of y that results from a rich multivariate world. T h e y are not "structural" in any way.
1 t

RANDOM W A L K IN G N P

895

d i v e r g e f r o m its p r e v i o u s l y forecast v a l u e f o l l o w i n g a shock. C a m p b e l l a n d M a n k i w (1987) o r i g i n a t e d a n d emphasize this i n t e r p r e t a t i o n . S e c o n d , o n e c a n m o d e l a series w h o s e fluctuations are p a r t l y t e m p o r a r y a n d p a r t l y p e r m a n e n t as a c o m b i n a t i o n o f a s t a t i o n a r y series a n d a r a n d o m walk. T h e r a n d o m walk carries the p e r m a n e n t p a r t o f a c h a n g e a n d t h e s t a t i o n a r y series c a r r i e s t h e t e m p o r a r y p a r t o f a c h a n g e . T h e n , o n e c a n ask h o w i m p o r t a n t t h e p e r m a n e n t o r r a n d o m w a l k c o m p o n e n t is t o t h e b e h a v i o r o f t h e series. I n a second i n t e r p r e t a t i o n , t h e m e a s u r e o f t h i s p a p e r asks t h e q u e s t i o n , H o w l a r g e is t h e v a r i a n c e o f shocks t o t h e r a n d o m w a l k o r p e r m a n e n t c o m p o n e n t o f G N P c o m p a r e d w i t h t h e v a r i a n c e o f y e a r l y G N P g r o w t h rates? O r , e q u i v a l e n t l y , H o w b i g is t h e r a n d o m w a l k i n G N P ? I f t h e v a r i a n c e o f t h e shocks t o t h e r a n d o m w a l k c o m p o n e n t is z e r o , t h e series is t r e n d - s t a t i o n a r y , a n d l o n g - t e r m forecasts d o n o t c h a n g e i n r e s p o n s e t o shocks. I f t h e v a r i a n c e o f t h e shocks t o t h e r a n d o m w a l k c o m p o n e n t is e q u a l t o t h e v a r i a n c e o f first d i f f e r e n c e s , t h e series is a p u r e r a n d o m w a l k . A s b e f o r e , t h e r e is a c o n t i n u o u s r a n g e o f possibilities b e t w e e n z e r o a n d o n e a n d b e y o n d o n e . A m o d e l consisting o f a r a n d o m walk plus a stationary c o m p o n e n t m a y seem q u i t e special. H o w e v e r , I s h o w b e l o w t h a t w e c a n t h i n k o f any series w h o s e g r o w t h rates o r first d i f f e r e n c e s are s t a t i o n a r y (any series w i t h a u n i t r o o t ) as a c o m b i n a t i o n o f a s t a t i o n a r y series p l u s a r a n d o m walk. T h e decomposition i n t o stationary and r a n d o m walk c o m p o n e n t s is a c o n v e n i e n t w a y o f t h i n k i n g a b o u t t h e p r o p e r t i e s o f a t i m e series, b u t i t a d d s n o s t r u c t u r e . I also s h o w t h a t t h e r e s p o n s e t o i n n o v a t i o n s is p r o p o r t i o n a l t o t h e s q u a r e r o o t o f t h e v a r i a n c e o f shocks t o a r a n d o m w a l k c o m p o n e n t , so w e c a n f r e e l y t r a n s f o r m b e t w e e n these t w o i n t e r p r e t a t i o n s . T h e i d e a t h a t G N P m a y c o n t a i n a r a n d o m w a l k goes back t o I r v i n g Fisher's " M o n t e C a r l o h y p o t h e s i s , " e x a m i n e d b y M c C u l l o c h ( 1 9 7 5 ) . T h e r e is n o w a l a r g e l i t e r a t u r e f o l l o w i n g t h e first h a l f o f N e l s o n a n d Plosser ( 1 9 8 2 ) t h a t a p p l i e s t h e D i c k e y a n d F u l l e r ( 1 9 7 9 , 1981) a n d s u b s e q u e n t tests f o r u n i t r o o t s t o a g g r e g a t e t i m e series. Since a series w i t h a u n i t r o o t is e q u i v a l e n t t o a series t h a t is c o m p o s e d o f a r a n d o m w a l k a n d a s t a t i o n a r y c o m p o n e n t , tests f o r a u n i t r o o t are a t t e m p t s t o d i s t i n g u i s h b e t w e e n series t h a t h a v e n o r a n d o m w a l k c o m p o n e n t ( o r f o r w h i c h t h e v a r i a n c e o f shocks t o t h e r a n d o m w a l k c o m p o n e n t is zero) a n d series t h a t h a v e a r a n d o m w a l k c o m p o n e n t ( o r f o r w h i c h t h e v a r i a n c e o f shocks t o t h e r a n d o m w a l k c o m p o n e n t is b e t w e e n z e r o a n d i n f i n i t y ) . Stated t h i s w a y , i t is clear w h y tests f o r a u n i t r o o t have l o w p o w e r : i t is h a r d t o t e l l a s t a t i o n a r y series f r o m a s t a t i o n a r y series plus a very small r a n d o m walk. T h i s paper a n d the related literature c i t e d i n i t g o b e y o n d t e s t i n g f o r t h e p r e s e n c e o r absence o f a u n i t r o o t

8 6
9

J O U R N A L OF P O L I T I C A L E C O N O M Y

or r a n d o m walk c o m p o n e n t a n d measure how i m p o r t a n t the u n i t root o r r a n d o m w a l k c o m p o n e n t is t o t h e b e h a v i o r o f a series.

Implications of the Random

Walk in GNP

T h e size o f a r a n d o m w a l k i n G N P is i m p o r t a n t f r o m a p u r e l y statistical v i e w p o i n t . M a n y statistical p r o c e d u r e s r e l y c r i t i c a l l y o n t h e d i s t i n c t i o n b e t w e e n series t h a t d o n o t c o n t a i n a r a n d o m w a l k c o m p o n e n t (1), w h i c h we can a n d s h o u l d d e t r e n d , a n d n e n t w h i c h we s h o u l d first-difference first-difference stationary series(3) b e l o w , o r series t h a t d o c o n t a i n a r a n d o m w a l k c o m p o p r i o r t o analysis. H y p o t h e s i s tests t h a t r e l y o n a s y m p t o t i c d i s t r i b u t i o n t h e o r y are a n i m p o r t a n t e x a m p l e because t h a t d i s t r i b u t i o n t h e o r y is o f t e n q u i t e sensitive t o t h e presence o f a r a n d o m w a l k c o m p o n e n t . A m e a s u r e m e n t o f t h e size o f t h e r a n d o m w a l k c o m p o n e n t c a n be a b e t t e r g u i d e t o t h e proper p r o c e d u r e t h a n a u n i t r o o t test because i f t h e r a n d o m w a l k c o m p o n e n t is s m a l l b u t still n o n z e r o , t h e n a n a s y m p t o t i c d i s t r i b u t i o n t h e o r y based o n t r e n d s t a t i o n a r i t y m a y p r o v i d e a b e t t e r a p p r o x i m a t i o n i n a g i v e n s m a l l s a m p l e t h a n t h e t h e o r y based o n a u n i t r o o t . T h e size o f a r a n d o m w a l k i n G N P has b e e n cast as a d i r e c t test between c o m p e t i n g models o f the economy. For example, Nelson and Plosser ( 1 9 8 2 ) i n t e r p r e t e d t h e i r r e s u l t t h a t G N P has a l a r g e r a n d o m w a l k c o m p o n e n t as e v i d e n c e f o r stochastic e q u i l i b r i u m m o d e l s o v e r t r a d i t i o n a l m o n e t a r y o r K e y n e s i a n business cycle m o d e l s . T h e y argued that t r a d i t i o n a l models produce only t e m p o r a r y deviations f r o m t r e n d , w h i l e m o d e l s t h a t find t h e u l t i m a t e source o f G N P v a r i a b i l i t y i n t e c h n o l o g y shocks c a n p r o d u c e p e r m a n e n t fluctuations. W i t h t h e a d v a n t a g e s o f h i n d s i g h t , i t n o w seems t h a t t h e size o r existence o f a r a n d o m w a l k c o m p o n e n t i n G N P c a n n o t d i r e c t l y d i s t i n g u i s h b r o a d classes o f e c o n o m i c t h e o r i e s o f t h e business cycle at t h e i r p r e s e n t stage o f d e v e l o p m e n t . T h e K y d l a n d a n d Prescott ( 1 9 8 2 ) a n d L o n g a n d Plosser ( 1 9 8 3 ) stochastic e q u i l i b r i u m m o d e l s w e r e c o n s t r u c t e d precisely t o g e n e r a t e t e m p o r a r y fluctuations about trend. O n t h e o t h e r h a n d , K i n g et a l . ( 1 9 8 7 ) s h o w t h a t o n e c a n m o d i f y these models to p r o d u c e a r a n d o m walk c o m p o n e n t by i n t r o d u c i n g a rand o m w a l k i n t h e t e c h n o l o g y shocks o r a l i n e a r t e c h n o l o g y f o r h u m a n or physical capital accumulation. Presumably, " K e y n e s i a n " m o d e l s as w e l l . F u r t h e r m o r e , t h e results o f t h i s p a p e r a r e c o m p a t i b l e w i t h a v a r i e t y o f r a n d o m walk components. I show below that an A R ( 2 ) about a d e t e r m i n i s t i c t r e n d , w h i c h has n o r a n d o m w a l k c o m p o n e n t , a n d a m o d e l w i t h a r a n d o m w a l k w h o s e v a r i a n c e is 0.18 t i m e s t h e v a r i a n c e o f first d i f f e r e n c e s o f l o g G N P a c c o u n t e q u a l l y w e l l f o r t h e results o f t h e same modifications w o u l d i n t r o d u c e a r a n d o m walk c o m p o n e n t i n t o m o n e t a r y o r

R A N D O M W A L K IN G N P

897

t h i s p a p e r . A l s o , t h e s t a n d a r d e r r o r s i n t h i s p a p e r are l a r g e , a n d I a r g u e t h a t t h i s is u n a v o i d a b l e . I c o n c l u d e t h a t t h e existence o r size o f a r a n d o m w a l k c o m p o n e n t i n G N P is n o t a precisely m e a s u r e d "styli z e d fact" t h a t we s h o u l d r e q u i r e a n y r e a s o n a b l e m o d e l t o r e p r o d u c e . T h e m o s t p r o m i s i n g d i r e c t use f o r t h e p o i n t estimates o f t h e size o f a r a n d o m w a l k c o m p o n e n t i n t h i s p a p e r m a y be t h e c a l i b r a t i o n o f a g i v e n m o d e l r a t h e r t h a n a test t h a t c a n d i s t i n g u i s h c o m p e t i n g classes o f m o d e l s . I f a m o d e l ( l i k e t h e ones c i t e d above) p r o d u c e s a r a n d o m w a l k i n G N P , t h e results o f t h i s p a p e r suggest t h a t t h e p a r a m e t e r s o f t h a t m o d e l s h o u l d be p i c k e d t o also g e n e r a t e i n t e r e s t i n g s h o r t - r u n d y n a m i c s o f G N P , so t h a t t h e v a r i a n c e o f y e a r l y changes i n G N P is m u c h l a r g e r t h a n t h e v a r i a n c e o f shocks t o its r a n d o m w a l k c o m p o nent.

Other

Estimates

Several a u t h o r s h a v e e s t i m a t e d t h e persistence o f fluctuations i n G N P , a n d t h e i r estimates v a r y g r e a t l y . N e l s o n a n d Plosser ( 1 9 8 2 ) matched a m o d e l consisting o f p e r m a n e n t and t e m p o r a r y compon e n t s t o a s t y l i z e d a u t o c o r r e l a t i o n f u n c t i o n f o r g r o w t h rates o f G N P a n d c o n c l u d e d t h a t t h e p e r m a n e n t c o m p o n e n t was m o r e i m p o r t a n t t h a n t h e t e m p o r a r y c o m p o n e n t . W a t s o n ( 1 9 8 6 ) a n d C l a r k ( 1 9 8 7 ) estimated d i f f e r e n t unobserved components models a n d f o u n d a small p e r m a n e n t c o m p o n e n t . C a m p b e l l a n d M a n k i w (1987) estimated the effect o f a shock o n l o n g - t e r m forecasts o f G N P f r o m t h e p a r a m e t e r s o f l o w - o r d e r autoregressive, m o v i n g average ( A R M A ) representations o f postwar G N P a n d f o u n d a large r a n d o m walk c o m p o n e n t . Several a u t h o r s h a v e e x a m i n e d t h e persistence o f fluctuations i n o t h e r t i m e series u s i n g a v a r i e t y o f m e t h o d s . Rose ( 1 9 8 6 ) presents a s u r v e y o f p a p e r s t h a t find l a r g e r a n d o m w a l k c o m p o n e n t s i n v a r i o u s m a c r o e c o n o m i c t i m e series. I n finance, c o n v e n t i o n a l w i s d o m f a v o r e d the r a n d o m walk m o d e l while macroeconomists favored the t r e n d stationary m o d e l . Poterba a n d Summers (1987), Fama a n d French ( 1 9 8 8 ) , a n d L o a n d M a c K i n l a y ( 1 9 8 8 ) use v a r i a n c e r a t i o e s t i m a t o r s similar to the one used i n this p a p e r a n d related estimators to docum e n t a t e m p o r a r y c o m p o n e n t i n stock prices. H u i z i n g a ( 1 9 8 7 ) uses a closely r e l a t e d e s t i m a t o r t o d o c u m e n t a t e m p o r a r y c o m p o n e n t i n r e a l e x c h a n g e rates. C o c h r a n e a n d S b o r d o n e ( 1 9 8 8 ) p r e s e n t a m u l t i v a r iate e x t e n s i o n .

This Paper's

Technique

I n t h i s p a p e r , I m e a s u r e t h e size o f a r a n d o m w a l k c o m p o n e n t i n G N P f r o m t h e v a r i a n c e o f its l o n g d i f f e r e n c e s . T h e i n t u i t i o n b e h i n d this

8 8
9

JOURNAL OF P O L I T I C A L

ECONOMY

m e a s u r e comes f r o m t h e f o l l o w i n g a r g u m e n t : I m a g i n e t h a t l o g G N P , d e n o t e d y , is a p u r e r a n d o m w a l k ( m o d e l [ 2 ] ) . T h e n t h e v a r i a n c e o f its ^ - d i f f e r e n c e s g r o w s l i n e a r l y w i t h t h e d i f f e r e n c e k: \ar(y y -k) kcrl. O n t h e o t h e r h a n d , i f l o g G N P is s t a t i o n a r y a b o u t a t r e n d ( m o d e l [1]), t h e v a r i a n c e o f its ^ - d i f f e r e n c e s a p p r o a c h e s a c o n s t a n t , t w i c e t h e u n c o n d i t i o n a l v a r i a n c e o f t h e series: var(y y -k) ~ ^ 2o^. N o w p l o t {\lk)\zx(y - y- ) as a f u n c t i o n o f k. I f y is a r a n d o m w a l k , t h e p l o t s h o u l d be c o n s t a n t at ai. I f y is t r e n d - s t a t i o n a r y , t h e p l o t s h o u l d decline t o w a r d zero.
t = t t t t t t k t t

N e x t , s u p p o s e t h a t fluctuations i n G N P are p a r t l y p e r m a n e n t a n d p a r t l y t e m p o r a r y , w h i c h w e c a n m o d e l as a c o m b i n a t i o n o f a s t a t i o n ary series a n d a r a n d o m w a l k . N o w t h e p l o t o f ( l / & ) v a r ( ; y , y -k) versus k s h o u l d settle d o w n t o t h e v a r i a n c e o f t h e shock t o t h e r a n d o m walk component.
t

I f fluctuations i n G N P are p a r t l y t e m p o r a r y i f t h e r a n d o m w a l k c o m p o n e n t is s m a l l a n d a s h o c k t o d a y w i l l be p a r t i a l l y r e v e r s e d i n t h e l o n g r u n t h a t r e v e r s a l is l i k e l y t o be slow, loosely s t r u c t u r e d , a n d n o t easily c a p t u r e d i n a s i m p l e p a r a m e t r i c m o d e l . T h e v a r i a n c e o f kd i f f e r e n c e s can find s u c h loosely s t r u c t u r e d r e v e r s i o n , w h e r e a s m a n y o t h e r approaches cannot. I show i n Section I V that this difference can r e c o n c i l e t h e results o f t h i s p a p e r w i t h o t h e r m e a s u r e s o f t h e p e r m a n e n c e o f fluctuations i n G N P .

Results F i g u r e 1 a n d table 1 p r e s e n t (l/k)\ar(y y -k) f o r l o g r e a l p e r c a p i t a GNP, 1 8 6 9 - 1 9 8 6 . P r e - 1 9 3 9 d a t a are t a k e n f r o m F r i e d m a n a n d S c h w a r t z ( 1 9 8 2 ) . I use r e a l p e r c a p i t a G N P t o e l i m i n a t e possible n o n stationarity i n d u c e d by inflation o r p o p u l a t i o n g r o w t h . ( H e n c e f o r t h , I w i l l r e f e r t o l o g r e a l p e r c a p i t a G N P as j u s t " G N P . " ) F i g u r e 1 a n d table 1 also i n c l u d e a s y m p t o t i c s t a n d a r d e r r o r s , discussed b e l o w . T a b l e 1 also presents \lk t i m e s t h e v a r i a n c e o f ^ - d i f f e r e n c e s d i v i d e d by t h e v a r i a n c e o f first d i f f e r e n c e s ( t h e v a r i a n c e r a t i o ) . T h e u n i t s i n table 1 a n d figure 1 are a n n u a l p e r c e n t a g e g r o w t h .
t t

Since l/k t i m e s t h e v a r i a n c e o f A-differences settles d o w n t o a b o u t o n e - t h i r d o f t h e v a r i a n c e o f first d i f f e r e n c e s , figure 1 a n d table 1 suggest t h a t t h e i n n o v a t i o n v a r i a n c e o f t h e r a n d o m w a l k c o m p o n e n t is a b o u t o n e - t h i r d o f t h e v a r i a n c e o f y e a r - t o - y e a r c h a n g e s : a n n u a l g r o w t h rates o f G N P c o n t a i n a l a r g e t e m p o r a r y c o m p o n e n t . I n fact, I show b e l o w t h a t t h e p a t t e r n o f figure 1 is consistent w i t h a d e t e r m i n istic t r e n d , w h i c h has no p e r m a n e n t o r r a n d o m w a l k c o m p o n e n t , a n d whose fluctuations a r e e n t i r e l y t e m p o r a r y . F i g u r e 2 p r e s e n t s t h e l o g o f r e a l p e r c a p i t a G N P . N o t i c e t h a t this d a t a set l o o k s as i f i t has a t r e n d i n i t . F l u c t u a t i o n s o c c u r , b u t t h e level

RANDOM W A L K IN G N P 8 99

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1/k var k - d i f f e r e n c e s - standard e r r o r s

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F I G . 1. \lk times the variance of dif Terences of log real per capita G N P , 1 8 6 9 1 9 8 6 , with asymptotic standard errors.

o f t h e series always r e t u r n s t o t h e " t r e n d l i n e . " F u r t h e r m o r e , t h a t t r e n d l i n e is l i n e a r : t h e r e are n o "waves" o f l o w f r e q u e n c y m o v e m e n t . T h e s e characteristics d r i v e t h e f i n d i n g o f a s m a l l r a n d o m w a l k c o m ponent. ( N o t e that lowfrequency m o v e m e n t generated by a n o n l i n e a r t r e n d , a s h i f t , etc. w o u l d s h o w u p as a l a r g e r a n d o m w a l k c o m p o n e n t i n this a n d m o s t o t h e r e s t i m a t i o n t e c h n i q u e s based o n l i n e a r timeseries m o d e l s . ) P r e w a r G N P d a t a are m o r e v a r i a b l e t h a n p o s t w a r data, a n d o n e m i g h t suspect t h a t t h i s c h a r a c t e r i s t i c d r i v e s t h e r e s u l t . H o w e v e r , f i g u r e 3 a n d table 1 p r e s e n t \lk t i m e s t h e v a r i a n c e o f / d i f f e r e n c e s f o r p o s t w a r G N P , a n d t h e same p a t t e r n is e v i d e n t . B o t h t h e v a r i a n c e o f first d i f f e r e n c e s a n d t h e v a r i a n c e o f t h e r a n d o m w a l k c o m p o n e n t are lower, but their p r o p o r t i o n s do not change m u c h .
2

T h e pattern of fig. 2 is sensitive to the precise specification of the variables. First, the variance of quarterly differences of seasonally adjusted G N P is less than onefourth the variance of yearly differences, so the variance ratio is higher if one uses quarterly rather than annual differences in the denominator. This observation explains most of the difference between fig. 2 and the results reported by Campbell and Mankiw ( 1 9 8 8 ) , who use a similar technique on quarterly data. Second, taking the variance of overlap ping Ayear differences of quarterly data vs. the variance of /t differences of annual averages, including or excluding population growth, taking logs or not, and even changing the sample by a few years can all change the variance ratio by about one standard error.


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go2

J O U R N A L OF P O L I T I C A L E C O N O M Y

R o m e r ( 1 9 8 6 ) a r g u e d t h a t p r e w a r G N P d a t a overstate t h e a c t u a l cyclical v a r i a b i l i t y o f G N P . T h i s p o s s i b i l i t y w i l l n o t bias t h e estimate o f t h e v a r i a n c e o f t h e r a n d o m w a l k c o m p o n e n t . T a k i n g ^-differences acts as a f i l t e r t h a t i g n o r e s cyclical fluctuations a n d c o n c e n t r a t e s o n t h e v a r i a b i l i t y o f l o n g e r " r u n s , " so a d i f f e r e n t G N P d a t a set w i l l h a v e a d i f f e r e n t v a r i a n c e o f A-differences i f t h e e a r l y G N P has a s i g n i f i c a n t l y d i f f e r e n t a n d m o r e v a r i a b l e t r e n d l i n e , n o t i f its cyclical fluctuations are d i f f e r e n t . A g r a p h s i m i l a r t o f i g u r e 1, u s i n g R o m e r ' s a d j u s t e d e a r l y G N P series, p r o d u c e s a v a r i a n c e o f a r a n d o m w a l k c o m p o n e n t v e r y s i m i l a r t o t h a t o f f i g u r e 1. I t s h o u l d because R o m e r k e p t t h e d e c a d e t r e n d s t h e same i n h e r c o r r e c t i o n s f o r cyclical v o l a t i l i t y . H e r c r i t i c i s m , o r t h e seasonal a d j u s t m e n t o f q u a r t e r l y d a t a , w i l l affect t h e v a r i a n c e o f first d i f f e r e n c e s , so t h e v a r i a n c e ratio c a n be biased b y excessive v o l a t i l i t y o r s m o o t h n e s s o f t h e first d i f f e r e n c e s . T h e presence o f a splice i n 1947 also does n o t d r i v e t h e r e s u l t . E v e r y l o n g series o f G N P d a t a c o n t a i n s at least o n e splice. T h e w i d e surveys used t o c o n s t r u c t l a t e r d a t a a r e s i m p l y n o t available f o r e a r l i e r p e r i o d s , so s o m e p r o j e c t i o n u s i n g a r e s t r i c t e d set o f i n d u s t r i e s is u n a v o i d a b l e . H o w e v e r , f o r c i n g t h e levels o f t h e " o l d " a n d " n e w " G N P series t o m a t c h at a c e r t a i n d a t e does n o t bias t h e v a r i a n c e o f kd i f f e r e n c e s . I t is biased o n l y i f t h e o l d series has d i f f e r e n t g r o w t h rates o v e r l o n g h o r i z o n s . T h e b o d y o f t h i s p a p e r consists o f a n i n v e s t i g a t i o n o f 1 Ik t i m e s t h e v a r i a n c e o f ^ - d i f f e r e n c e s as a n e s t i m a t e o f t h e r a n d o m w a l k c o m p o n e n t i n G N P . S e c t i o n I I p r o v i d e s several i n t e r p r e t a t i o n s o f a r a n d o m w a l k c o m p o n e n t . S e c t i o n I I I discusses e s t i m a t i o n . S e c t i o n I V r e c o n ciles these results w i t h p r e v i o u s r e s e a r c h t h a t f o u n d a l a r g e r a n d o m w a l k c o m p o n e n t b y s h o w i n g h o w c o n v e n t i o n a l time-series e s t i m a t i o n t e c h n i q u e s c a n p r o v i d e m i s l e a d i n g estimates o f a r a n d o m w a l k c o m ponent. Section V contains a s u m m a r y a n d c o n c l u d i n g remarks.

II.

U n i t Roots and R a n d o m Walk Components

T h i s section discusses a n d d o c u m e n t s several c l a i m s i n t h e I n t r o d u c t i o n a b o u t t h e r e p r e s e n t a t i o n o f t i m e series. I t shows t h a t firstd i f f e r e n c e s t a t i o n a r y t i m e series o r t i m e series w i t h a u n i t r o o t are e q u i v a l e n t t o t i m e series t h a t are c o m p o s e d o f a s t a t i o n a r y a n d a r a n d o m w a l k c o m p o n e n t . I t a r g u e s t h a t t h e v a r i a n c e o f shocks t o a r a n d o m w a l k c o m p o n e n t is j u s t a c o n v e n i e n t i n t e r p r e t a t i o n o f t h e p a r a m e t e r s o f a n a r b i t r a r y f i r s t - d i f f e r e n c e s t a t i o n a r y series, b u t i t r e q u i r e s n o a d d i t i o n a l s t r u c t u r e . I t shows h o w t o t r a n s f o r m b e t w e e n the variance o f a r a n d o m w a l k c o m p o n e n t a n d the response o f longt e r m forecasts t o a shock.

RANDOM WALK I N GNP

903

Assume that log G N P follows a first-difference stationary linear process; t h a t is, g r o w t h rates o f G N P a r e s t a t i o n a r y . I n t h i s case, l o g GNP has a m o v i n g a v e r a g e r e p r e s e n t a t i o n o f t h e f o r m
00

by

= ( 1 - L)y

= - + A(L)e

+ ^ aje j=0
t

j9

(3)

w h i c h I t a k e as t h e s t a r t i n g p o i n t ; L is t h e l a g o p e r a t o r , Ly = y - \. T h e
t t

first e q u a l i t y d e f i n e s t h e n o t a t i o n ky a n d ( 1 L)y f o r first d i f f e r e n c e s

t t

o f y . T h e last e q u a l i t y defines t h e l a g p o l y n o m i a l n o t a t i o n A ( L ) . T h e e,
t

are i n d e p e n d e n t i d e n t i c a l l y d i s t r i b u t e d ( i . i . d . ) e r r o r t e r m s w i t h c o m mon variance af. T h e r a n d o m w a l k process ( 2 ) o b v i o u s l y has a r e p r e s e n t a t i o n o f t h e f o r m ( 3 ) . T h e t r e n d - s t a t i o n a r y process ( 1 ) is a l i m i t i n g case o f (3): i f \i = b a n d i f t h e l a g p o l y n o m i a l A(L) i n (3) has a u n i t r o o t t h a t is, w e = (1 L)B(L)we r e c o v e r ( 1 ) by c a n c e l i n g t h e components m o d e l s are first( 1 L ) . Many unobserved c a n e x p r e s s A(L) terms

difference stationary a n d hence have a r e p r e s e n t a t i o n (3). N e l s o n a n d Plosser ( 1 9 8 2 ) a n d W a t s o n ( 1 9 8 6 ) are e x a m p l e s . O n t h e o t h e r h a n d , (3) does n o t i n c l u d e n o n l i n e a r processes s u c h as Q u a h ( 1 9 8 6 ) , a p r o cess w i t h a n o n l i n e a r t r e n d , o r s e c o n d - d i f f e r e n c e s t a t i o n a r y processes ( t h e g r o w t h rates o f G N P f o l l o w a r a n d o m w a l k ) as i n C l a r k ( 1 9 8 7 ) . G i v e n t h e r e p r e s e n t a t i o n ( 3 ) , w e h a v e t h e f o l l o w i n g fact. FACT 1. A n y first-difference s t a t i o n a r y processes c a n be repre s e n t e d as t h e s u m o f s t a t i o n a r y a n d r a n d o m w a l k c o m p o n e n t s . T o s h o w t h a t a r e p r e s e n t a t i o n as s t a t i o n a r y p l u s r a n d o m w a l k c o m p o n e n t s exists, we s i m p l y c o n s t r u c t i t f r o m t h e r e p r e s e n t a t i o n (3). T h i s d e c o m p o s i t i o n comes f r o m B e v e r i d g e a n d N e l s o n ( 1 9 8 1 ) . L e t y where
o o
t

= z

+ c

tf

(4)

z = + z -i
t t

+ ( ]T aM \j = o '
o o

tf

o o

o o
fl

-c

= ( X

fl

;) *

+ ( Z

;) '-i

+ ( X <)-2

+ = z + k\x,\

T h i s d e c o m p o s i t i o n is c o n s t r u c t e d so t h a t lim^oo E y
t t t

t+k

t h a t is, l o n g - t e r m forecasts o f y c o n v e r g e t o z p l u s k\L. I n t h i s sense, z is t h e p e r m a n e n t c o m p o n e n t o f y . B e v e r i d g e a n d N e l s o n call i t a

t t

stochastic t r e n d . L o n g - t e r m forecasts o f y are u n a f f e c t e d b y c

t

the is

temporary component. T h e i n n o v a t i o n variance o f the r a n d o m walk c o m p o n e n t a |

z

natural measure o f the importance o f the r a n d o m walk component.

904

J O U R N A L OF P O L I T I C A L E C O N O M Y

F r o m t h e d e f i n i t i o n (4) w e c a n w r i t e t h e v a r i a n c e o f t h e r a n d o m w a l k component v\
z

i n t e r m s o f t h e m o v i n g average r e p r e s e n t a t i o n ( 3 ) : <jL = Oaf** = (5)

(sums w i t h o u t i n d i c e s r u n f r o m z e r o t o i n f i n i t y ) . I n t h e B e v e r i d g e a n d N e l s o n d e c o m p o s i t i o n (4), t h e i n n o v a t i o n s i n t h e r a n d o m w a l k a n d s t a t i o n a r y c o m p o n e n t s are i d e n t i c a l . I n a m o r e general c o m b i n a t i o n o f r a n d o m walk a n d stationary components, the i n n o v a t i o n s m a y be c o r r e l a t e d : y = z + c

t t tf

Z, = f l + Z , _ ! + T],, c = B(L)b ,
t t t

(6)

E(r\

b) a r b i t r a r y .
t

I f w e start w i t h a process ( 6 ) , Ay is s t a t i o n a r y , a n d so t h e process has a r e p r e s e n t a t i o n o f t h e f o r m ( 3 ) . M o s t processes o f t h e f o r m (3) c a n be d e c o m p o s e d i n t o a v a r i e t y o f processes ( 6 ) , w i t h v a r y i n g c o r r e l a t i o n b e t w e e n t h e i n n o v a t i o n s ; b u t o n l y t h e d e c o m p o s i t i o n (4) is guaranteed to exist.
3

Since a v a r i e t y o f d e c o m p o s i t i o n s i n t o s t a t i o n a r y a n d r a n d o m w a l k c o m p o n e n t s o f t h e f o r m (6) exist f o r a n y g i v e n s t a t i o n a r y process (3), a m e a s u r e based o n t h e v a r i a n c e o f t h e r a n d o m w a l k c o m p o n e n t w o u l d be i n serious t r o u b l e i f i t d e p e n d e d c r u c i a l l y o n w h i c h a r b i t r a r y d e c o m p o s i t i o n w e choose. F o r t u n a t e l y , i t does n o t , as seen i n t h e f o l l o w i n g fact. F A C T 2. I n e v e r y d e c o m p o s i t i o n o f a process (1) i n t o s t a t i o n a r y a n d r a n d o m walk c o m p o n e n t s (6), the i n n o v a t i o n variance o f the r a n d o m w a l k c o m p o n e n t is t h e same: a | = (Xa ) (T
2 2 z 7

T o s h o w fact 2, start w i t h a n a r b i t r a r y d e c o m p o s i t i o n (6). T h e c o r r e s p o n d i n g m o v i n g average r e p r e s e n t a t i o n o f t h e f o r m (3) is (1 - L)y

t

= + v + (1 - L)B(L)b
t

+ A(L)e .
t

(7)

T h e last e q u a l i t y defines t h e p a r a m e t e r s A(L) o f a m o v i n g average r e p r e s e n t a t i o n f r o m t h e p a r a m e t e r s B(L) o f (6). N o w f o r m t h e B e v e r i d g e a n d N e l s o n d e c o m p o s i t i o n o f b o t h sides o f t h e last e q u a l i t y i n (7). Since t h e processes o n b o t h sides o f t h e last e q u a l i t y are t h e same, t h e y m u s t have t h e same v a r i a n c e o f a r a n d o m w a l k c o m p o n e n t , so w e m u s t h a v e | A ( l ) | a = a . T h e c o r r e l a t i o n b e t w e e n v a n d
4 2 2 2 t

Watson (1986) derives this fact. For example, if we seek a representation with uncorrelated innovations, the spectral density of the combination can be no less than the spectral density of each component; thus such a representation exists only if the spectral density of the first differences has a global minimum at zero. T h i s statement can be more compactly derived by noting that for the processes on each side of the last equality in (7) to be the same, their spectral densities must be the same at all frequencies, and zero in particular.
3 4

RANDOM WALK I N GNP

t

95

b is i r r e l e v a n t f o r t h i s a r g u m e n t , so t h e i n n o v a t i o n v a r i a n c e o f e v e r y d e c o m p o s i t i o n (6) o f t h e same m o v i n g a v e r a g e r e p r e s e n t a t i o n (3) m u s t h a v e t h e same v a r i a n c e o f shocks t o t h e r a n d o m w a l k c o m p o n e n t . T h i s a r g u m e n t d e m o n s t r a t e s fact 2. T h e r e is o n e m o r e i n t e r p r e t a t i o n , w h i c h w i l l be u s e f u l i n t h e n e x t section. T h e s p e c t r a l d e n s i t y o(ky is, b y ( 1 ) , S (e~ ) = |A(e"")| a . T h e r e f o r e , w e h a v e t h e f o l l o w i n g fact.
5 lUi 2 2 t Ay

F A C T 3. T h e i n n o v a t i o n v a r i a n c e o f t h e r a n d o m w a l k c o m p o n e n t is e q u a l t o t h e s p e c t r a l d e n s i t y o f Ay at f r e q u e n c y z e r o , t h a t is,
t

(8) or, d i v i d i n g by t h e v a r i a n c e o f first d i f f e r e n c e s , (8') E q u a t i o n s (8) a n d ( 8 ' ) s u m m a r i z e t h r e e e q u i v a l e n t ways o f l o o k i n g at t h e l o n g - r u n p r o p e r t i e s o f a series: w e c a n b r e a k i t i n t o p e r m a n e n t ( r a n d o m walk) a n d t e m p o r a r y (stationary) components, we can examine t h e r e s p o n s e o f l o n g - t e r m forecasts t o a n i n n o v a t i o n , o r w e can e x a m i n e t h e s p e c t r a l d e n s i t y at f r e q u e n c y z e r o o f its first d i f f e r e n c e s . A l l t h r e e i n t e r p r e t a t i o n s a l l o w us t o t h i n k o f t h e p e r m a n e n c e o f t h e fluctuations i n a series as a c o n t i n u o u s p h e n o m e n o n r a t h e r t h a n a discrete c h o i c e . F u r t h e r m o r e , e q u a t i o n s (8) a n d ( 8 ' ) s h o w t h a t t h e q u a n t i t y a | o r (j\j(j\y d e f i n e d f r o m t h e B e v e r i d g e a n d N e l s o n dec o m p o s i t i o n (3) is n o m o r e t h a n a u s e f u l i n t e r p r e t a t i o n o f t h e s u m o f t h e m o v i n g a v e r a g e coefficients Say. T h e d e c o m p o s i t i o n i n t o s t a t i o n ary a n d r a n d o m w a l k c o m p o n e n t s a d d s n o s t r u c t u r e .
2

T h e v a r i a n c e o f shocks t o t h e r a n d o m w a l k c o m p o n e n t o r s p e c t r a l d e n s i t y at f r e q u e n c y z e r o o f f i r s t d i f f e r e n c e s also c a p t u r e s all t h e effects o f a u n i t r o o t o n t h e b e h a v i o r o f a series i n a f i n i t e s a m p l e . A s a s a m p l e o f T o b s e r v a t i o n s o f a series is c o m p l e t e l y c h a r a c t e r i z e d b y its T 1 a u t o c o v a r i a n c e s , i t is also c o m p l e t e l y c h a r a c t e r i z e d b y T 1 p e r i o d o g r a m o r d i n a t e s . B y c h a n g i n g t h e p e r i o d o g r a m o r d i n a t e at f r e q u e n c y z e r o o f first d i f f e r e n c e s w i t h o u t c h a n g i n g t h e o t h e r s , we can m a k e a s t a t i o n a r y series i n t o a series w i t h a u n i t r o o t o r r a n d o m w a l k c o m p o n e n t a n d vice v e r s a .
6

Since t h e size o f a r a n d o m w a l k c o m p o n e n t is a c o n t i n u o u s choice, a n y test f o r t r e n d s t a t i o n a r i t y ( a | = 0 o r S y(e~ ) = 0) m u s t have a r b i t r a r i l y l o w p o w e r against t h e a l t e r n a t i v e o f a s m a l l e n o u g h r a n t0 2 A

I use the notation S(e~ ) for the spectral density at frequency u> and, hence, S(e ) for the spectral density at u = 0. > With an infinite sample, or in population, this proposition does not hold. T h e spectral density is defined only almost everywhere; and in some cases we can bound the variation of the population spectral density function with very weak assumptions.
5 tbi l 6

go6
z

J O U R N A L OF P O L I T I C A L E C O N O M Y

d o m w a l k c o m p o n e n t v \ . A s a r e s u l t , e f f o r t s t o c a t e g o r i z e series as trend-stationary o r difference-stationary a n d read great things i n t o t h e d i f f e r e n c e b e t w e e n t h e t w o w i l l n o t be v e r y f r u i t f u l .

III.

Estimation

I claimed i n the I n t r o d u c t i o n that the variance o f ^-differences c o u l d be u s e d t o e s t i m a t e t h e i n n o v a t i o n v a r i a n c e o f a r a n d o m w a l k c o m ponent. T o d o c u m e n t that claim and to provide standard errors, this section discusses t h e statistical p r o p e r t i e s o f t h e v a r i a n c e o f kdifferences.

Asymptotic Properties L e t <ik d e n o t e l/k t i m e s t h e p o p u l a t i o n v a r i a n c e o f ^-differences o f y erf = k~ v a r ( ^ y -k)\ "1 is r e l a t e d t o t h e a u t o c o r r e l a t i o n coeffi cients o f Ay, b y
l t9 t

<rf = ( l + 2 X j p - P i ) ^

( )
9

w h e r e a\ = var(y - y - ) a n d p, = co\ {by by -j) I a\ . T h e d e r i v a t i o n is s t r a i g h t f o r w a r d b u t t e d i o u s , so i t is p r e s e n t e d i n t h e A p p e n d i x . E q u a t i o n (9) shows t h a t t h e l i m i t o f cr is i n d e e d t h e i n n o v a t i o n v a r i ance o f t h e r a n d o m w a l k c o m p o n e n t :

y t t x t t y 2

00

lim

<rf = ( l + 2 X

Pj) *l,

= ^

(10)

T h e second e q u a l i t y is t h e d e f i n i t i o n o f s p e c t r a l d e n s i t y , w h i l e t h e t h i r d is r e p r o d u c e d f r o m e q u a t i o n ( 8 ) . E q u a t i o n (9) suggests t h a t w e c o u l d also estimate Ilk t i m e s t h e v a r i a n c e o f /^-differences b y u s i n g s a m p l e a u t o c o r r e l a t i o n s p i n t h e place o f t h e i r p o p u l a t i o n values py. ( H u i z i n g a [ 1 9 8 7 ] a n d C a m p b e l l a n d M a n k i w [ 1 9 8 8 ] p e r f o r m t h e c a l c u l a t i o n t h i s way.) T h e r i g h t - h a n d side o f (9) w i t h p, i n place o f p, is t h e d e f i n i t i o n o f t h e B a r t l e t t es t i m a t o r o f t h e s p e c t r a l d e n s i t y at f r e q u e n c y z e r o ( A n d e r s o n 1 9 7 1 , p . 511). H e n c e , l/k t i m e s t h e v a r i a n c e o f / - d i f f e r e n c e s is a s y m p t o t i c a l l y equivalent to the Bartlett estimator.
7 7

\lk times the variance of ^-differences and the conventional Bartlett estimate are not identical in small samples. T h e estimates of sample autocorrelations implied by the sample variance of ^-differences underweight observations k dates away from the endpoints, compared with the usual estimates of autocorrelation. T h e difference disap pears asymptotically but may be important in small samples. Also, the conventional Bartlett estimate is not unbiased in small samples, as the corrected Mk times the vari ance of ^-differences is for a random walk. I thank John Huizinga for pointing this out.
7

RANDOM W A L K IN G N P

907

T h e p r o p e r t i e s o f t h e B a r t l e t t e s t i m a t o r are w e l l k n o w n , so w e c a n establish t h e a s y m p t o t i c p r o p e r t i e s o f l/k t i m e s t h e v a r i a n c e o f kd i f f e r e n c e s by r e f e r e n c e t o those o f t h e B a r t l e t t e s t i m a t o r . I n p a r t i c u l a r , (1) i f //> 0 as T > 00, w h e r e T is t h e s a m p l e size, l/k t i m e s t h e s a m p l e v a r i a n c e o f / - d i f f e r e n c e s is a consistent estimate o f t h e spec t r a l d e n s i t y at f r e q u e n c y z e r o ; (2) t h e a s y m p t o t i c v a r i a n c e o f is 4kS (e- )/3T ( A n d e r s o n 1971, p. 531).
2 2 l0

T h e e q u i v a l e n c e b e t w e e n l/k t i m e s t h e v a r i a n c e o f / - d i f f e r e n c e s and the Bartlett estimator provides a useful interpretation o f the v a r i a n c e o f /^-differences f o r r e a d e r s f a m i l i a r w i t h s p e c t r a l d e n s i t y e s t i m a t i o n ; i n t u r n , t h e v a r i a n c e o f / - d i f f e r e n c e s is a u s e f u l a n d i n t u i tive t i m e d o m a i n c o u n t e r p a r t t o t h e B a r t l e t t s p e c t r a l d e n s i t y es t i m a t o r . T o use t h e B a r t l e t t e s t i m a t o r , we have t o d e c i d e w h a t k t o use: h o w m a n y a u t o c o v a r i a n c e s o r a u t o c o r r e l a t i o n s t o i n c l u d e i n (9) o r h o w m a n y p e r i o d o g r a m ordinates to s m o o t h . T h e choice o f k re q u i r e s a t r a d e - o f f b e t w e e n bias a n d efficiency, a n d i t is u s u a l l y m a d e a r b i t r a r i l y . I n this c o n t e x t , a p l o t o f l/k t i m e s t h e v a r i a n c e o f kd i f f e r e n c e s versus k is a n e x p e r i m e n t a l d e t e r m i n a t i o n o f t h e p r o p e r k or window width.

Small-Sample

Properties

I n s m a l l samples, l/k t i m e s t h e v a r i a n c e o f / - d i f f e r e n c e s a n d t h e B a r t l e t t e s t i m a t o r can be biased, a n d t h e a s y m p t o t i c s t a n d a r d e r r o r s m a y be a p o o r a p p r o x i m a t i o n t o t h e a c t u a l s t a n d a r d e r r o r s . I n this subsec t i o n , I discuss c o r r e c t i o n s f o r s m a l l - s a m p l e bias, a n d I p r e s e n t s o m e M o n t e C a r l o e x p e r i m e n t s to evaluate standard errors. I c o r r e c t e d f o r t w o sources o f s m a l l - s a m p l e bias i n t h e s a m p l e v a r i ance o f / - d i f f e r e n c e s . T h e s e c o r r e c t i o n s p r o d u c e a n e s t i m a t o r o f cr t h a t is u n b i a s e d w h e n a p p l i e d t o a p u r e r a n d o m w a l k w i t h d r i f t . F i r s t , I u s e d t h e s a m p l e m e a n o f t h e first d i f f e r e n c e s t o estimate t h e d r i f t t e r m p, at a l l k r a t h e r t h a n e s t i m a t e a d i f f e r e n t d r i f t t e r m at each k f r o m the m e a n o f the /-differences. Second, I i n c l u d e d a degrees o f f r e e d o m c o r r e c t i o n TI(T k + 1). W i t h o u t t h i s c o r r e c t i o n , l/k t i m e s t h e v a r i a n c e o f / - d i f f e r e n c e s declines t o w a r d z e r o as k > T f o r a n y process because y o u c a n n o t t a k e a v a r i a n c e w i t h o n e d a t a p o i n t .
2

I w i l l use t h e n o t a t i o n d t o d e n o t e l/k t i m e s t h e b i a s - c o r r e c t e d s a m p l e v a r i a n c e o f /^-differences. T h e f o r m u l a f o r d is p r e s e n t e d i n t h e A p p e n d i x as e q u a t i o n ( A 3 ) . T h e A p p e n d i x also c o n t a i n s a p r o o f t h a t d is u n b i a s e d w h e n y is a r a n d o m w a l k w i t h d r i f t .

2 2 2 t

T a b l e 2 presents s t a n d a r d e r r o r s f r o m a M o n t e C a r l o e x p e r i m e n t u s i n g 100 o b s e r v a t i o n s o f a r a n d o m w a l k w i t h d r i f t . I p i c k e d t h e i n n o v a t i o n v a r i a n c e o f this r a n d o m w a l k cr = a | = 1. T h e m e a n o f d was v e r y close t o o n e at a l l k i n t h i s e x p e r i m e n t , c o n f i r m i n g t h e bias c o r r e c t i o n s f o r a p u r e r a n d o m w a l k . T h e table p r e s e n t s t h e s t a n d a r d

2 2 2

JOURNAL OF POLITICAL ECONOMY TABLE 2

M O N T E C A R L O S T A N D A R D E R R O R S F O R \lk

T I M E S T H E VARIANCE OF k DIFFERENCES

Model: =

y -1
t

/;

erf = \(T \00k/T

= 100, 500 trials)

1 Monte Carlo Bartlett* .137 .115

2 .160 .163
;)

3 .200 .200

4 .231 .231

5 .263 .258

10 .409 .365

20 .607 .516

30 .772 .632

40 .888 .730

50 .896 .816

* This row gives (4k/3T) .

errors f r o m the M o n t e Carlo e x p e r i m e n t a n d the corresponding Bartlett standard errors for comparison. T h e Bartlett errors slightly u n d e r s t a t e t h e M o n t e C a r l o e r r o r s at l a r g e kIT, b u t t h e d i f f e r e n c e is s m a l l c o m p a r e d t o t h e size o f t h e s t a n d a r d e r r o r s . M o n t e C a r l o e x p e r i m e n t s w i t h d i f f e r e n t s a m p l e sizes a n d r a n d o m w a l k v a r i a n c e c o n f i r m t h a t t h e s t a n d a r d e r r o r s o f table 2 scale w i t h kIT a n d t h e i n n o v a t i o n variance o f the r a n d o m walk. W h a t a b o u t processes t h a t are m o r e c o m p l i c a t e d t h a n a p u r e r a n d o m w a l k ? T h e A p p e n d i x p r e s e n t s a d e r i v a t i o n o f ( d ) f o r a first o r d e r m o v i n g average: (1 L)y = p + (1 + 6L)e,. I t shows t h a t ( d ) a p p r o a c h e s f o r l a r g e k, so cr c a n r e c o v e r t h e v a r i a n c e o f t h e r a n d o m w a l k c o m p o n e n t f o r t h i s process as w e l l .
2 t 2 2 2

I r a n several f u r t h e r M o n t e C a r l o s i m u l a t i o n s t o e x a m i n e w h e t h e r t h e v a r i a n c e o f / d i f f e r e n c e s is r o b u s t w h e n a p p l i e d t o m o r e c o m p l i c a t e d processes f o r G N P . I fit a v a r i e t y o f A R M A processes t o first d i f f e r e n c e s o f l o g r e a l p e r c a p i t a G N P , s i m u l a t e d 118 o b s e r v a t i o n s o f each process, a n d c o m p u t e d d i n 100 t r i a l s . I n each case, t h e m e a n o f d at k = 3 0 was e q u a l t o t h e v a r i a n c e o f t h e r a n d o m w a l k c o m p o n e n t i m p l i e d b y t h e e s t i m a t e d A R M A processesk = 30 was l a r g e e n o u g h to identify the r a n d o m walk f r o m the stationary c o m p o n e n t s a n d t h e s t a n d a r d e r r o r s at l a r g e k w e r e close t o those i m p l i e d b y table 2, scaled t o t h e v a r i a n c e o f t h e r a n d o m w a l k c o m p o n e n t .
2 2

A l l t h e l o w o r d e r A R M A processes p r o d u c e d d lines t h a t rise f o r k f r o m 1 t o 5 a n d t h e n are flat at t h e v a r i a n c e o f t h e r a n d o m w a l k c o m p o n e n t f r o m k = 10 o n , u n l i k e figure 1. T h e y i m p l i e d a | > | T w o processes t h a t d o c a p t u r e t h e b e h a v i o r o f figure 1 are a n A R ( 1 5 ) , figure 4, a n d A R ( 2 ) a b o u t a d e t e r m i n i s t i c t r e n d , figure 5. I n t h e n e x t section, I w i l l discuss w h y t h e l o w o r d e r A R M A m o d e l s f a i l e d t o c a p t u r e t h e b e h a v i o r o f figure 1. F o r n o w , n o t e t h a t since t h e y r e p l i cate t h e b e h a v i o r o f d f o r G N P , figures 4 a n d 5 c a n p r o v i d e s m a l l s a m p l e s t a n d a r d e r r o r s . T h e s e s t a n d a r d e r r o r s are s i m i l a r t o t h e a s y m p t o t i c s t a n d a r d e r r o r s u s e d i n figure 1.
2 2

F i g u r e s 4 a n d 5 also i n c l u d e d

for G N P from

figure

1, m a r k e d

F I G . 4.Monte Carlo simulation of an A R ( 1 5 )

F I G . 5.Monte Carlo simulation of an A R ( 2 ) with a linear trend

giO

J O U R N A L OF P O L I T I C A L ECONOMY

d f ( G N P ) . Since t h e d f ( G N P ) l i n e falls i n s i d e t h e o n e - s t a n d a r d - e r r o r b a n d s , n e i t h e r m o d e l c a n be r e j e c t e d f o r r e a l G N P . H o w e v e r , t h e s t a n d a r d e r r o r s f r o m t h e r a n d o m w a l k (table 2) o r a n y o f t h e o t h e r l o w - o r d e r A R M A processes are l a r g e e n o u g h t h a t w e c a n n o t reject t h e m at 5 p e r c e n t e i t h e r . ( N o t e t h a t t h e s t a n d a r d e r r o r s scale w i t h t h e size o f t h e r a n d o m w a l k c o m p o n e n t . U n d e r t h e h y p o t h e s i s o f a r a n d o m w a l k , t h e s t a n d a r d e r r o r s are b i g g e r t h a n i n d i c a t e d i n fig. 1.) A c o n f i d e n c e i n t e r v a l i n c l u d e s b o t h v \ l a \ = 0 a n d 1.
z y

W h i l e this is u n f o r t u n a t e , I w i l l a r g u e b e l o w t h a t estimates o f a r a n d o m w a l k c o m p o n e n t are l i m i t e d by t h e n u m b e r o f n o n o v e r l a p p i n g " l o n g r u n s " i n t h e d a t a set, so t h a t l a r g e efficiency gains are n o t possible w i t h o u t i m p o s i n g a d d i t i o n a l s t r u c t u r e o n t h e time-series p r o cess f o r G N P . A s a r e s u l t , t h i s a n d r e l a t e d exercises c a n p r o v i d e a p o i n t estimate o f t h e size o f a r a n d o m w a l k c o m p o n e n t w i t h associ a t e d s t a n d a r d e r r o r s b u t w i l l n o t p r o v i d e u s e f u l tests t o d i s c r i m i n a t e b e t w e e n m o d e l s t h a t i m p l y v a r i o u s sizes o f t h e r a n d o m w a l k c o m ponent. T h e parameters o f the A R ( 1 5 ) m o d e l i m p l y that the variance ratio .18, w h i l e t h e A R ( 2 ) a b o u t a t r e n d i m p l i e s v\ /v\ = 0. H e n c e , t h e s i m u l a t i o n s b e h i n d figures 4 a n d 5 also r e v e a l a n upward bias i n d f as a n e s t i m a t e o f t h e r a n d o m w a l k c o m p o n e n t w h e n t h e series has a s m a l l r a n d o m w a l k c o m p o n e n t o r is t r e n d - s t a t i o n a r y .
z y

I n s u m m a r y , Ilk t i m e s t h e v a r i a n c e o f / - d i f f e r e n c e s d p r o v i d e s a n upward-biased p o i n t estimate o f the variance ratio | / | o f about .34, a n d t w o models w i t h a ^ / a ^ = .18 a n d 0 replicate the b e h a v i o r o f t h e v a r i a n c e o f / - d i f f e r e n c e s o f G N P . H o w e v e r , s t a n d a r d e r r o r s are l a r g e e n o u g h t h a t w e c a n n o t statistically reject v a r i a n c e r a t i o s b e t w e e n z e r o a n d o n e at c o n v e n t i o n a l levels o f significance.
2 2

IV.

Reconciliation with Previous Estimates

Given the definition o f the r a n d o m walk c o m p o n e n t i n terms o f the p a r a m e t e r s o f a m o v i n g a v e r a g e r e p r e s e n t a t i o n , (4) o r (8) above, t h e o b v i o u s t h i n g t o d o is e i t h e r t o e s t i m a t e a p a r s i m o n i o u s time-series m o d e l f o r Ay, a n d calculate 2 a o r t o i d e n t i f y a n d estimate a s i m p l e p a r a m e t r i c u n o b s e r v e d c o m p o n e n t s m o d e l l i k e (4). C a m p b e l l a n d M a n k i w ( 1 9 8 7 ) a n d N e l s o n a n d Plosser ( 1 9 8 2 ) d i d j u s t t h a t , respec tively, a n d b o t h f o u n d l a r g e r a n d o m w a l k c o m p o n e n t s . W h y d o N e l son a n d Plosser a n d C a m p b e l l a n d M a n k i w find l a r g e r a n d o m w a l k c o m p o n e n t s , w h i l e W a t s o n ( 1 9 8 6 ) , C l a r k ( 1 9 8 7 ) , a n d I find s m a l l ones? T h o u g h t h e r e are s m a l l d i f f e r e n c e s i n d e f i n i t i o n w h i c h q u a n tities w e l o o k at t o m e a s u r e t h e i m p o r t a n c e o f u n i t r o o t s o r r a n d o m w a l k c o m p o n e n t s t h e m a j o r d i f f e r e n c e is i n e s t i m a t i o n strategies.
7

RANDOM W A L K I N G N P N e l s o n a n d Plosser s p e c i f i e d a n u n o b s e r v e d c o m p o n e n t s m o d e l o f the form y (1 L)u

t t

= u =

v,
t

+ A(L)e
t t

e, i . i . d . ,

(11)

v (e
t

= B(L)b ,

b i.i.d.

and b

m a y be c o r r e l a t e d ) . T h e y i d e n t i f i e d t h e t w o c o m p o n e n t s

f r o m a s t y l i z e d a u t o c o r r e l a t i o n f u n c t i o n o f G N P g r o w t h rates. I f t h e first 0L). a u t o c o r r e l a t i o n o f Ay is p o s i t i v e b u t t h e o t h e r s a r e z e r o , t h e n t h e

t

o n l y m o d e l o f t h e f o r m ( 1 1 ) t h a t w o r k s is A(L) By examining plausible parameter m o d e l , N e l s o n a n d Plosser c o n c l u d e d t h a t cr

2 >

1 a n d B(L) for o"!8

= (1 + restricted rep

values

this

C a m p b e l l a n d M a n k i w (1987) estimated parsimonious A R M A

r e s e n t a t i o n s o f l o g G N P , u s i n g seasonally a d j u s t e d q u a r t e r l y p o s t w a r data. T h e y measured the i m p o r t a n c e o f the r a n d o m walk c o m p o n e n t by Sa

7

= A ( l ) , t h e c h a n g e i n z ( t h e l o n g - t e r m forecast) i n r e s p o n s e t o
t

a unit univariate innovation i n G N P . T h e y

f o u n d values f o r A ( l )

equal to o r larger t h a n one, w h i c h i m p l y an i n n o v a t i o n variance o f the r a n d o m w a l k c o m p o n e n t g r e a t e r t h a n t h e v a r i a n c e o f first d i f f e r e n c e s of GNP.

9

T h i s measure of the importance of a random walk component has the conceptual disadvantage that it depends on which arbitrary unobserved components decomposi tion we choose. For example, since every series of the form (11) has a unique moving average representation, we could rewrite (11) as (1 - L)y = fx + C{L)v , v i.i.d., and eliminate the stationary component. Alternatively, we could use the Beveridge and Nelson decomposition of Sec. I I to make the component with a unit root into a pure random walk:
8 t t t

y = z + Ct,
t t

(1 L)z = | i + v ,
t t

v i.i.d.,
t

c = C{L)i
t

i i.i.d.
t

These representations are observationally equivalent to the first form (11), but the measure <j\I<j\ changes according to which one we choose. I n contrast, the innovation variance of a random walk component is invariant to the choice of decomposition (fact 2 in Sec. I I ) . Also, the ratio of the innovation variance of the two components is not a good measure of their relative importance because the proportion of the variance of Ay explained by u and v depends on the coefficients of A(L) and B(L) as well as the ratio
t t t

T h e r e are some conceptual disadvantages to scaling a persistence measure by the univariate innovations of y . T h e univariate innovations are not observable and must be inferred from a model; the univariate innovations do not correspond to the "surprise" movement because we live in a multivariate environment; a series may have small innovations but a large variance. For example, , = 1.5,_ - . 9 5 , _ + For this process, Zaj = 2 . 2 2 but u\Ju% = (1 ) /(1]) = 0 . 2 0 . However, for the G N P data used in this paper, there is little qualitative difference between the two definitions, and the difference in results must be explained by differences in estimation strategy.
9 t x 2 2 ;

Q12

J O U R N A L OF P O L I T I C A L ECONOMY

I n p e r f o r m i n g t h e M o n t e C a r l o s i m u l a t i o n s o f S e c t i o n I I , I also f o u n d t h a t l o w - o r d e r A R M A m o d e l s o f G N P i m p l y t h a t cr s h o u l d rise w i t h k, a n d t h e y i m p l y a l a r g e r a n d o m w a l k c o m p o n e n t , w h i l e i n fact cr d e c l i n e s a n d t h e e s t i m a t e d r a n d o m w a l k c o m p o n e n t is s m a l l . T o r e p l i c a t e t h e b e h a v i o r o f cr f o r G N P , I h a d t o estimate a n A R ( 1 5 ) o r impose a deterministic t r e n d .

2 2 2

T o i n v e s t i g a t e t h i s fact f u r t h e r , I f i t a v a r i e t y o f A R M A processes t o G N P g r o w t h rates, r a n g i n g f r o m w h i t e noise o u t t o a n A R ( 1 5 ) (see table 3 ) . A l l r e p r e s e n t a t i o n s past w h i t e noise are a d e q u a t e by u s u a l s t a n d a r d s : t h e D u r b i n - W a t s o n statistics are close t o 2, t h e significance levels o f t h e Q-statistic a r e a r o u n d .5, t h e p a r a m e t e r s o f o v e r f i t m o d e l s are statistically i n s i g n i f i c a n t , a n d so f o r t h . B u t t h e v a r i a n c e r a t i o a n d 2 a start at a b o u t 1.2 f o r s e c o n d - o r d e r processes a n d d e c l i n e steadily t o a v a r i a n c e r a t i o o f .18 a n d 2 a = .5 f o r a n A R ( 1 5 ) . L o w - o r d e r A R M A m o d e l s systematically o v e r e s t i m a t e t h e r a n d o m w a l k c o m p o n e n t o f G N P , e v e n t h o u g h t h e y a d e q u a t e l y r e p r e s e n t t h e series b y a l l t h e u s u a l d i a g n o s t i c tests. T h e q u e s t i o n is, w h y ?
1 0 7 7

T h e i n n o v a t i o n v a r i a n c e o f a r a n d o m w a l k c o m p o n e n t is a p r o p e r t y o f t h e v e r y l o n g - r u n b e h a v i o r o f a series a l o n e . I t is t h e s p e c t r a l d e n s i t y at t h e f r e q u e n c y o> = 0 c o r r e s p o n d i n g t o a p e r i o d o r " r u n " o f i n f i n i t y , i t is r e l a t e d t o t h e i n f i n i t e s u m o f t h e m o v i n g a v e r a g e coefficients | 2 a | o r t h e a u t o c o r r e l a t i o n coefficients (1 + 2 S p ) , a n d i t c o r r e s p o n d s t o t h e e f f e c t o f a s h o c k t o d a y o n forecasts i n t o t h e i n f i n i t e f u t u r e . I n t h e o r y , t h e n , w e s h o u l d h a v e t o w a i t a n infinite a m o u n t o f t i m e t o get j u s t o n e o b s e r v a t i o n o n t h e size o f t h e r a n d o m w a l k c o m ponent!
2 7 7

I n p r a c t i c e , we t y p i c a l l y b e l i e v e t h a t t h e d y n a m i c r e s p o n s e o f G N P t o a s h o c k is flat a f t e r a s u i t a b l e l o n g r u n has a r r i v e d . T h i s b e l i e f is i m p l i c i t above: t h e g r a p h s s t o p a f t e r t h e t h i r t i e t h d i f f e r e n c e , reflecti n g a b e l i e f t h a t a f t e r 30 years t h e t e m p o r a r y effects o f business cycles are o v e r . T h e n u m b e r o f n o n o v e r l a p p i n g l o n g r u n s is a r o u g h g u i d e t o t h e n u m b e r o f d e g r e e s o f f r e e d o m (precisely, t h e n u m b e r o f per i o d o g r a m o r d i n a t e s ) i n t h i s exercise. W i t h a 1020-year l o n g r u n t h e r e are n o m o r e t h a n five t o 10 i n d e p e n d e n t o b s e r v a t i o n s i n 100 years o f d a t a a n d t w o t o f o u r o b s e r v a t i o n s i n p o s t w a r d a t a . O b v i o u s l y , u s i n g m o r e f r e q u e n t l y s a m p l e d d a t a does n o t h e l p . Estimating an unobserved components m o d e l or a parsimonious
1 1

I used the RATS program to perform the estimation. Autoregressive models are estimated by ordinary least squares and moving average models by conditional maximum likelihood. T h e unreported moving average models did not converge. Precisely, if the coefficients of the moving average representation (1) are zero past a long-run value M < o, then the derivative of the spectral density of Ay at zero is bounded. I f y is in fact trend-stationary and the spectral density of A3; at frequency zero is in fact zero, then the slope of the spectral density of A3; at zero is also zero.
1 0 1 1 t

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9 4

JOURNAL OF P O L I T I C A L ECONOMY

A R M A m o d e l is a n a t t e m p t t o c i r c u m v e n t this p r o b l e m . T h e s e m o d els m a k e i d e n t i f y i n g r e s t r i c t i o n s across f r e q u e n c i e s : t h e y d r a w i n ferences a b o u t t h e l o n g - r u n ( h i g h - o r d e r a u t o c o r r e l a t i o n o r l o w frequency) dynamics f r o m a m o d e l fit to the s h o r t - r u n (low-order autocorrelation o r high-frequency) dynamics. For an example that d e m o n s t r a t e s h o w " e f f e c t i v e " these p r o c e d u r e s are, C a m p b e l l a n d M a n k i w ( 1 9 8 7 ) r e p o r t estimates s u c h as A ( l ) = 1.306 .073 f o r t h e 20-year forecast o f G N P . Since t h e r e a r e o n l y t w o n o n o v e r l a p p i n g 20-year forecasts i n t h e i r d a t a set, i t is clear h o w h e a v i l y t h e i r esti mates o f A ( l ) d e p e n d o n t h e i d e n t i f y i n g a s s u m p t i o n t h a t t h e series follow a given low-order A R M A model. I f t h e s h o r t - a n d l o n g - r u n d y n a m i c s o f G N P c a n b o t h be c a p t u r e d by t h e a s s u m e d time-series m o d e l , these p r o c e d u r e s c a n h e l p estima t i o n because w e h a v e m u c h m o r e d a t a o n h i g h - f r e q u e n c y fluctuations. H o w e v e r , i f t h e l o n g - r u n d y n a m i c s c a n n o t be c a p t u r e d i n t h e m o d e l used t o s t u d y t h e s h o r t r u n , these i d e n t i f i c a t i o n p r o c e d u r e s bias c o n clusions a b o u t l o n g - r u n b e h a v i o r . I o f f e r t w o ways t o see t h i s fact. F i r s t , r e c a l l t h a t t h e v a r i a n c e o f t h e shock t o t h e r a n d o m w a l k c o m p o n e n t is r e l a t e d t o t h e s u m o f t h e autocorrelations by

W h e n w e m o d e l s h o r t - r u n d y n a m i c s , w e safely i g n o r e h i g h - o r d e r statistically i n s i g n i f i c a n t a u t o c o r r e l a t i o n s o r w e s l i g h t l y misspecify t h e m b y fitting a s i m p l e m o d e l . B u t a l l a u t o c o r r e l a t i o n s e n t e r i n t o (12) e q u a l l y , so a l a r g e n u m b e r o f s m a l l h i g h - o r d e r a u t o c o r r e l a t i o n s c a n offset a few l a r g e l o w - o r d e r a u t o c o r r e l a t i o n s . S e c o n d , G N P g r o w t h has a p o s i t i v e a u t o c o r r e l a t i o n at s h o r t lags a n d a s m a l l r a n d o m w a l k c o m p o n e n t at l o n g lags. A s i m p l e t i m e series m o d e l m a y n o t be able t o c a p t u r e b o t h k i n d s o f b e h a v i o r . F o r e x a m p l e , i f (1 - L)y = |x + (1 + 0L)e,, w e n e e d 0 > 0 t o c a p t u r e p o s i t i v e first-order a u t o c o r r e l a t i o n b u t 0 < 0 t o c a p t u r e a s m a l l r a n d o m w a l k c o m p o n e n t . Faced w i t h a c h o i c e , m a x i m u m l i k e l i h o o d esti mates m a t c h t h e s h o r t - r u n b e h a v i o r ( t h e y fit 0 > 0 i n t h e e x a m p l e ) and misrepresent the l o n g - r u n behavior.
t

T h e A p p e n d i x c o n t a i n s a d e m o n s t r a t i o n o f this p r o p e r t y o f m a x i m u m l i k e l i h o o d estimates. I t shows t h a t m a x i m u m l i k e l i h o o d esti mates o f a m o d e l s u c h as a l o w - o r d e r A R M A o r a s i m p l e p a r a m e t r i c unobserved components m o d e l pick parameters that match the m o d el's a n d t h e a c t u a l s p e c t r a l d e n s i t y o v e r t h e e n t i r e f r e q u e n c y r a n g e . T h e r e f o r e , m a x i m u m l i k e l i h o o d w i l l sacrifice accuracy i n t h e s m a l l r e g i o n a r o u n d = 0 t o b e t t e r m a t c h s p e c t r a l densities at h i g h e r frequencies.

RANDOM W A L K IN GNP

915

I n summary, the l o w - o r d e r A R M A approach o f C a m p b e l l and M a n k i w a n d the unobserved components approach o f Nelson a n d Plosser c a n n o t m a t c h t h e s h o r t - r u n d y n a m i c s a n d t h e s m a l l r a n d o m w a l k c o m p o n e n t i n t h e l o n g - r u n d y n a m i c s at t h e same t i m e . Faced w i t h the choice, they capture the s h o r t - r u n dynamics a n d incorrectly i m p l y large r a n d o m walk components. O n the o t h e r h a n d , Clark's (1987) a n d Watson's (1986) decomposi tions can accommodate the behavior o f G N P i n b o t h frequency ranges. (See, e.g., W a t s o n ' s fig. lb, i n w h i c h h e shows h o w his m o d e l can represent a large n u m b e r o f small h i g h - o r d e r autocorrelations t h a t a l o w - o r d e r A R M A c a n n o t m a t c h . ) B o t h W a t s o n a n d C l a r k find a s m a l l r a n d o m w a l k c o m p o n e n t . H o w e v e r , t h e i r d e c o m p o s i t i o n s also i m p l y i d e n t i f y i n g restrictions to estimate l o n g - r u n behavior f r o m s h o r t - r u n d y n a m i c s . Since these r e s t r i c t i o n s are n o m o r e o r less p l a u sible t h a n N e l s o n a n d Plosser's o r C a m p b e l l a n d M a n k i w ' s , t h e y m i g h t n o t be able t o c a p t u r e t h e p a t t e r n o f h i g h - o r d e r c o r r e l a t i o n s i n o t h e r d a t a sets as t h e y seem t o d o f o r G N P . Since t h e size o f t h e r a n d o m w a l k c o m p o n e n t is a p r o p e r t y o f t h e p e r i o d o g r a m o r d i n a t e at f r e q u e n c y z e r o a l o n e , any e s t i m a t i o n t e c h n i q u e m u s t m a k e s o m e i d e n t i f y i n g r e s t r i c t i o n across t h e f r e q u e n c y r a n g e . T h e v a r i a n c e o f /^-differences assumes t h a t past a c e r t a i n k t h e r a n d o m w a l k c o m p o n e n t is a d e q u a t e l y i d e n t i f i e d , e m p i r i c a l l y d e t e r m i n e d as t h e p o i n t i n w h i c h t h e g r a p h ( f i g . 1) flattens o u t . T h e r e f o r e , the variance o f /-differences (or any o t h e r spectral w i n d o w estimator) uses 1020-year p e r i o d i n f o r m a t i o n t o i d e n t i f y t h e i n f i n i t e - r u n p r o p e r t y , t h e r a n d o m w a l k c o m p o n e n t . T h e v a r i a n c e o f /^-differences does n o t use i n f o r m a t i o n a b o u t d y n a m i c s at business cycle f r e q u e n c i e s t o i d e n t i f y l o n g - r u n m o v e m e n t s , a n d t h i s is its i m p o r t a n t a d v a n t a g e .

V.

Conclusion

T h e v a r i a n c e o f ^ - d i f f e r e n c e s ( f i g . 1 a n d table 1) p r o d u c e d a p o i n t estimate t h a t t h e i n n o v a t i o n v a r i a n c e o f t h e r a n d o m w a l k c o m p o n e n t o f G N P is a b o u t o n e - t h i r d t h e v a r i a n c e o f y e a r l y G N P g r o w t h rates. T h a t estimate is u p w a r d biased f o r s m a l l r a n d o m w a l k c o m p o n e n t s : the parameters o f two models that replicated the behavior o f the v a r i a n c e o f ^ - d i f f e r e n c e s o f G N P i m p l i e d v a r i a n c e r a t i o s o f .18 (AR(15)) and 0 (AR(2) about a deterministic trend). I conclude that i f t h e r e is a r a n d o m w a l k c o m p o n e n t i n G N P at a l l , i t is s m a l l . A n o t h e r w a y t o c h a r a c t e r i z e these results, w i t h o u t r e f e r e n c e t o r a n d o m w a l k c o m p o n e n t s , is t h a t G N P g r o w t h is p o s i t i v e l y a u t o c o r r e l a t e d at s h o r t lags, b u t t h e r e are m a n y s m a l l n e g a t i v e a u t o c o r r e l a t i o n s at l o n g lags. T h e s e b r i n g f u t u r e G N P back t o w a r d , i f n o t a l l t h e way back t o , its p r e v i o u s l y forecast v a l u e f o l l o w i n g a shock.

gi6

JOURNAL OF P O L I T I C A L ECONOMY

T h e s e results d o not m e a n t h a t " G N P f o l l o w s a n A R ( 2 ) a b o u t a d e t e r m i n i s t i c t r e n d . " O u r forecasts o f t h e f u t u r e m a y q u i t e r i g h t l y be m u c h m o r e v a r i a b l e t h a n t h e " t r e n d " i n G N P w e h a v e seen i n t h e r e c e n t 118-year past m i g h t s u g g e s t . AR(2)
12

T h e s e results do m e a n t h a t a n

about a deterministic t r e n d or a difference-stationary A R M A

process w i t h a v e r y s m a l l r a n d o m w a l k c o m p o n e n t is a g o o d i n - s a m p l e characterization o f the behavior o f G N P . I n r e c o n c i l i n g these results w i t h p r e v i o u s research, I a r g u e d t h a t c o n v e n t i o n a l c r i t e r i a f o r time-series m o d e l i d e n t i f i c a t i o n a n d estimat i o n c a n p r o d u c e m i s l e a d i n g estimates o f t h e r a n d o m w a l k c o m p o n e n t o f a series l i k e G N P . T h e r a n d o m w a l k c o m p o n e n t is a p r o p e r t y o f all autocorrelations taken together, but conventional procedures c o n c e n t r a t e o n t h e first f e w a u t o c o r r e l a t i o n s i n o r d e r t o p a r s i m o n i ously c a p t u r e s h o r t - r u n d y n a m i c s . W h e n u s e d t o estimate t h e size o f a r a n d o m w a l k c o m p o n e n t , t h e y i m p o s e i d e n t i f y i n g r e s t r i c t i o n s across t h e f r e q u e n c y r a n g e t o i n f e r t h e l o n g - r u n p r o p e r t i e s o f a series f r o m its s h o r t - r u n d y n a m i c s . I a r g u e d t h a t , i n t h e absence o f c r e d i b l e i d e n t i f y i n g r e s t r i c t i o n s , i t is best t o leave t h e s h o r t r u n o u t a l t o g e t h e r , as the variance o f ^-differences o r some o t h e r spectral w i n d o w estimator does. H o w e v e r , this v i e w t h a t w e s h o u l d use o n l y l o n g - r u n p r o p e r t i e s o f G N P data to estimate the l o n g - r u n behavior o f G N P i m p l i e s that s t a n d a r d e r r o r s o f u n i v a r i a t e estimates o f t h e r a n d o m w a l k c o m p o nent will r e m a i n large i n c e n t u r y - l o n g macroeconomic data and l a r g e r still i n p o s t w a r m a c r o e c o n o m i c d a t a because t h e r e are i n h e r e n t l y f e w n o n o v e r l a p p i n g l o n g r u n s available. T h e s e o b s e r v a t i o n s arg u e against t h e r e s e a r c h s t r a t e g y t h a t says t h a t t h e presence o f a u n i t r o o t a n d t h e size o f a r a n d o m w a l k c o m p o n e n t a r e c r u c i a l a n d w e l l d o c u m e n t e d s t y l i z e d facts t h a t a n y t h e o r e t i c a l m o d e l m u s t r e p l i c a t e .

Appendix
A. Derivation of Equation (9) Start w i t h
00

( 1 - L)y

= jx + A ( L ) e , =

+ X
7 = 0

J*'-r

< >
A1

A plausible model for G N P should have some random walk component. I f G N P is truly stationary about a linear trend, then the variance of the forecast error of the level of G N P is the same for all dates in the far future. As long as there is some random walk component, the variance of forecast errors will grow unboundedly over the forecast horizon. However, only a very small random walk component is required to achieve this desirable property.
1 2

RANDOM W A L K I N G N P

917
2

Using (1 - L*)(l L)~

l

= (1 + L + L
k-

+ . . . +
J

L~)
00

(A2)
FL

yt

yt-k

k\L

+ X
j = 0

( X
V = 0

FL

<) < - ; + X
I j = k

<)
I

<-r

\l = j - k + \

T a k i n g its variance,
_k-1

af - A " v a r ( * 1

2(2')' S( 2
L =o\/=o
7

'

) = / = ;'-*+1

T o simplify the algebra, express erf as a difference equation k<r\ - (k l)af_! =

[ +
L =o V
7

/=i

1 +

2 7=1

a? L)^, p =
7

where p = the 7th autocorrelation o f (1 Therefore,

7

27= 0 #/#/+/27=0

= k ~ [ l + (1 + 2p i) + (1 + 2
l

P l

+ 2p ) + . . . ] = ! + 2 X T ^ - P r
2

B. Derivation o / E ( c r ) for an MA(1)

2

Assume that ( A l ) takes the f o r m (1 - L)y = fx + (1 -h 6L)*,

t

and assume that e, are i.i.d. n o r m a l . T h e data set is T + 1 observations o f the levels o f y or T observations o f its first differences. By definition,
t

of =

(7 - )(7

- + 1) j
k

(A3)

Equation (2) specializes to

-1

yj-

k\L

+ e, + , . * + (1 + ) X

7-

and similarly for ;y - jy - Collecting terms i n e, and noting that (,*) = 0 i f 7 7^ we get (after some algebra)
r 0

(a )
4

F<Ah

- + fl^2 - (1 + ) a . -

26 1 + (k IT )
2 2

- [2k/T(T - k -

1)]

a..

i8
2 k 2 2 2 k

J O U R N A L OF P O L I T I C A L E C O N O M Y
2 2

Note that (1) as E(& ) [(1 + 8 ) (28/)]cr ; (2) as , k < , E(& ) (1 + 8) cr = c r L ; (3) for 6 = 0, (<r ) = a = a | for all such that k < T.
2 2 2

C.

How Maximum Likelihood Imposes Identifying Restrictions across Frequencies

t

L e t x , = (1 L)y = A(L)e,. Assume that A(0) = 1, that A(L) is onesided and has zeros outside the u n i t circle, so that the spectral density o f x is bounded away f r o m zero, and that A has an inverse, so that x has an autoregressive representation B(L)x = e,. Consider estimating A(L) or B(L) by m a x i m u m likelihood via a simple timeseries or unobserved components model. For simplicity, assume infinite data, e, ~ iV(0, cr ), and cr known. (The same point survives generalization to more complex estimation environments.) I n this case, m a x i m u m likelihood is equivalent to
t 2 2

m i n E[B(L)x ]
t

subject to B(L) E

(A4)

where B(L) is the autoregressive representation o f the estimated model, and is the restricted space o f autoregressive representations allowed by the chosen timeseries model. Since variance is the integral o f spectral density, (A4) is the same as
min(2'7T
l

\B(e- ")\ S (e- )do)

x

til,

subject to B(e~ ) E
ltt>

(A5)

T h e following expression is equivalent: min \(~ )

- B(e- )\ S (e- )do>

x 2

tbi

tbi

subject to {~ )
2

(A6)

T o see this, expand \B B\ and substitute AA*cr = S (an asterisk denotes complex conjugation; I d r o p p e d the ~ '). T h e n (A6) becomes
x

min

(BB* + BB* - BB* - B*B)AA*do>.

1

(A7)

T h e first t e r m is j u s t (A5). Since A t h i r d and f o u r t h are

= B, the second t e r m is 2, and the

* (BA + B*A*)do>.

U n d e r the assumption that A and are onesided and that A (0) = B(0) = 1,
00 00

j " BAdu

= j"

+ X

V"^

+ X

aje-^dm;

since J*% ~ > = 0, BAdo> = B*A*do> = 2. Therefore, (A6) reduces to (A5) plus constants. Equation (A6) is analogous to Sims's (1972) a p p r o x i m a t i o n formula, repro duced i n Sargent (1979, p. 293). T h e message o f (A6) is that m a x i m u m likelihood attempts to match the frequency response o f the autoregressive representation across the entire frequency range, weighted by the true spec tral density o f x . T h e m e t h o d o f m a x i m u m likelihood will sacrifice accuracy
t

RANDOM W A L K IN GNP

919

o f the estimated (~ ) at a point i n the frequency range ( = 0) i n order to achieve a better fit over an interval. Similarly, it will sacrifice accuracy i n a small window (20 years to infinity is /10 wide) to gain accuracy i n a large window (24 years is /2 wide). I f S (e~ ) is smaller near = 0 than else where, as the variance o f ^-differences suggests for GNP, then (A6) shows that m a x i m u m likelihood further deemphasizes accuracy i n windows about zero.
lt,> x

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Macroeconomic T i m e Series: Some Evidence and Implications."/. Monetary Econ. 10 (September 1982): 139-62. Poterba, James M . , and Summers, Lawrence H . "Mean Reversion i n Stock Prices: Evidence and Implications." W o r k i n g Paper no. 2343. Cambridge, Mass.: N B E R , 1987. Quah, Danny. "What Do We Learn f r o m U n i t Roots i n Macroeconomic T i m e Series?" Manuscript. Cambridge: Massachusetts Inst. Tech., 1986. Romer, Christina D . "The Prewar Business Cycle Reconsidered: New Estimates o f Gross National Product, 1869-1918." W o r k i n g Paper no. 1969. Cambridge, Mass.: N B E R , July 1986. Rose, A n d r e w K . "Unit-Roots and Macroeconomic Models." Manuscript. Berkeley: Univ. California, 1986. Sargent, Thomas J. Macroeconomic Theory. New Y o r k : Academic Press, 1979. Sims, Christopher A . " T h e Role o f A p p r o x i m a t e Prior Restrictions i n Distributed Lag E s t i m a t i o n . " / . American Statis. Assoc. 67 (March 1972): 169-75. Watson, M a r k W . "Univariate D e t r e n d i n g Methods w i t h Stochastic Trends." /. Monetary Econ. 18 (July 1986): 4 9 - 7 5 .