Reconciling Output Gaps: Unobserved Components Model and Hodrick-Prescott Filter
24 Pages Posted: 20 Jul 2016
Date Written: June 2016
Abstract
This paper reconciles two widely used trend-cycle decompositions of GDP that give markedly different estimates: the correlated unobserved components model yields output gaps that are small in amplitude, whereas the Hodrick-Prescott (HP) filter generates large and persistent cycles. By embedding the HP filter in an unobserved components model, we show that this difference arises due to differences in the way the stochastic trend is modeled. Moreover, the HP filter implies that the cyclical components are serially independent — an assumption that is decidedly rejected by the data. By relaxing this restrictive assumption, the new model provides comparable model fit relative to the standard correlated unobserved components model.
Keywords: trend-cycle decomposition, HP filter, structural break
JEL Classification: C11, C52, E32
Suggested Citation: Suggested Citation