Working Paper: CEPR ID: DP4244
Authors: Albert Marcet; Morten Ravn
Abstract: Many empirical studies have applied the Hodrick-Prescott filter in cross-country comparisons of business cycle fluctuations. The Hodrick-Prescott filter involves the smoothing parameter l, and standard practice in the literature is to set this parameter equal to 1600 (in quarterly data) for all countries. We show that this choice might distort the results when the cyclical component is highly serially correlated, and that care should be taken in checking if the results are unreasonable in the light of common wisdom. For example, for Spanish data we show that, contrary to conventional wisdom, the results imply that the Spanish cycle is very smooth and that the period of 1975-85 was one of macroeconomic tranquility. We propose to recast the HP-filter as a constrained minimization problem, which selects endogenously a value of l that imposes cross-country consistency of the imposed constraint. Our proposed method is easy to apply and retains all the virtues of the standard HP-filter. When applied to Spanish data, the results imply a return to conventional wisdom and we find results in line with economic historian?s views. We also examine data for a number of OECD countries and find that, with the exception of Spain, Italy and Japan, the standard choice of l = 1600 is sensible.
Keywords: Business cycles; Cross-country comparisons; Macroeconomic volatility
JEL Codes: C32; E32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Fixed smoothing parameter (1600) (C54) | Distortion of business cycles representation (E32) |
| Fixed smoothing parameter (1600) (C54) | Misrepresentation of cyclical characteristics in Spain (E32) |
| Proposed adjustment method (C51) | Increased perceived volatility of Spanish business cycle (E32) |
| Proposed adjustment method (C51) | Alignment with historical consensus (N00) |
| Standard choice of 1600 (C52) | Suitable for most countries except Japan (F29) |
| Standard application of HP filter (C58) | Distortion of understanding of business cycles (E32) |