Characterizing the Business Cycle

Hodrick-Prescott Filter
First-differencing eliminates the trend component but it
amplifies the effect of high frequency noise
 • Y(t) denotes the actual GDP at time t, the trend component is
denoted Ytg and the cyclical component Ytc.
• The mean value of the cyclical component is 1 (an assumption
that is convenient as will be seen below). In other words,

Yt = Yt g × Yt c
E[Yt ] = Yt g
ln(Yt ) = ln(Yt g ) + ln(Yt c )
E[Yt c ] = 1
y t = ln(Yt ) g t = ln(Yt g ) ct = ln(Yt c )
y t = g t + ct
There are, potentially, many different models that can be
used. For example, we may assume that the growth rate is
constant over time. This implies that the trend is a straight
line (a linear trend). The cyclical component is then current
GDP growth minus a constant growth term.

But, we know that (or we may assume that) the long-term

growth rate varies slowly over time. If this is the case,
with a straight line as the trend we obtain a poor
estimate of the cyclical component. We, then, need
another model that we can use to extract the cyclical
component from GDP.
 A bit of mathematics
Yt = Yt g × Yt c
ln(Yt ) = ln(Yt g ) + ln(Yt c )
yt = g t + ct
ct = yt − g t
Y g
+ Y − Y g
Yt +∆
g
∆
ct = ln(Yt ) − ln(Yt g ) = ln( t t t
) = ln( ) ≈
Yt g Yt g Yt g

The cyclical component represents the relative deviation

of the GDP from its long-run growth path.
 T
HP Filter
min ∑ ( yt − g t ) 2 + λ[( g t − g t −1 ) − ( g t −1 − g t − 2 )]2
t =1
If λ=0, the trend component coincides with the original time series.
The cyclical component is zero.

If λ tends to infinity, the HP filter ends up to be a linear trend, i.e

the growth rate would be constant over time.

The value of λ is
• Yearly data λ=100
• Quarterly data λ=1600
• Monthly data λ=14400
 Figure 1.2
Natural Logarithm of Per Capita Real
GDP
Yt = Yt g × Yt c
ln(Yt ) = ln(Yt g ) + ln(Yt c )
yt = g t + ct

1-7 © 2014 Pearson Education, Inc.

 Figure 1.3
Natural Logarithm of Per Capita Real GDP
and Trend
Yt = Yt g × Yt c
ln(Yt ) = ln(Yt g ) + ln(Yt c )
yt = g t + ct

1-8 © 2014 Pearson Education, Inc.

 Figure 1.4
Percentage Deviations from Trend in
Per Capita Real GDP

Yt = Yt g × Yt c
ln(Yt ) = ln(Yt g ) + ln(Yt c )
yt = g t + ct
ct = yt − g t

1-9 © 2014 Pearson Education, Inc.

 Figure 3.9
Percentage Deviations from Trend in
Real Consumption and Real GDP
 Figure 3.10
Percentage Deviations from Trend in
Real Investment and Real GDP
 Table 3.1
Correlation Coefficients and Variability of
Percentage Deviations from Trend
 Table 3.2
Summary of Business Cycle Facts