Permanent and Transitory Components of Real GDP

*Sigh.* Greg Mankiw writes:>Greg Mankiw’s Blog: Team Obama on the Unit Root Hypothesis: [W]hen I read the [Obama] CEA’s forecast analysis, this sentence jumped out at me:>>a key fact is that recessions are followed by rebounds. Indeed, if periods of lower-than-normal growth were not followed by periods of higher-than-normal growth, the unemployment rate would never return to normal.>That is, according to the CEA, because we are now experiencing below-average growth, we should raise our growth forecast in the future to put the economy back on trend in the long run…. Some years ago, I engaged in a small intellectual skirmish over this topic along with my coauthor John Campbell…. “According to the conventional view of the business cycle, fluctuations in output represent temporary deviations from trend. The purpose of this paper is to question this conventional view…. The data suggest that an unexpected change in real GNP of 1 percent should change one’s forecast by over 1 percent over a long horizon…”Mankiw is here arguing that the Obama administration’s forecast is too high, and so forecasts future deficits that are smaller than the deficits are in fact likely to be. Mankiw is arguing that future economic growth is likely to be just average–that there will be no post-recession catch-up during which growth is faster than average.Whether an unexpected fall in production is followed by faster than average catch-up growth depends what kind the fall in production is. A fall in production that does not also change the unemployment rate will in all likelihood be permanent. A fall in production that is accompanied by a big rise in the unemployment rate will in all likelihood be reversed. You have to do a bivariate analysis–to look at two variables, output and unemployment. You cannot do a univariate analysis and expect to get anything useful out.Guess what kind of unexpected fall in production we are experiencing right now?That an unemployment rate higher than normal is likely to be followed by a period when unemployment falls sharply is sure. On average, we expect half of deviations of unemployment from its average value to be erased over the next two years:


And those post-recession periods of falling unemployment are also times of rapid output growth. On average, we expect cumulative growth over the next two years to be higher by three-quarters of a percentage point for each one percentage point of higher unemployment now:


But Greg Mankiw knows this. At the bottom of his column he writes:>I should note that there is much to forecasting beyond the univariate models in my work with Campbell…In other words, he notes that when constructing a real forecast it makes no sense to ignore the information in the unemployment rate. And:>[O]ur paper, of course, was only one piece of a large literature. The CEA might well be right…And that is certainly the way to bet.


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