Cyclical Trends in Continuous Time Models

Joanne S. Ercolani

University of Birmingham

September 25, 2007

ABSTRACT It is undoubtedly desirable that econometric models capture the dynamic behaviour, like trends and cycles, observed in many economic processes. Building models with such capabilities has been an important objective in the continuous time econometrics literature, see for instance the cyclical growth models of Bergstrom (1966), the complete economywide macroeconometric models of, for example, Bergstrom and Wymer (1976), unobserved stochastic trends of Harvey and Stock (1988 and 1993) and Bergstrom (1997), and dierential-dierence equations of Chambers and McGarry (2002). This papers contribution is to examine cyclical trends formulated in continuous time, which complement the trend-plus-cycle models that are frequently used in the unobserved components literature.

Keywords: Cyclical Trends, continuous time models, stochastic dierential equations, dierentialdierence equations. JEL Classication: C22.

The author would like to thank Marcus Chambers and Ralph Bailey for their helpful comments. Any

errors remain my own. Address correspondence to: Department of Economics, 90 Vincent Drive, University of Birmingham, Edgbaston, Birmingham, B15 2TT; email: J.S.Ercolani@bham.ac.uk.

1. INTRODUCTION This paper proposes cyclical trend models within a continuous time unobserved components framework, thus contributing to the literature on modelling trends and cycles in continuous time. This was an area in which Rex Bergstrom showed a great interest, although his approach was somewhat dierent to that considered here. One objective of Bergstroms research was to model the movements of the principal variables in the economy using continuous time dynamic systems. His aim was to formulate systems of dierential equations in economic variables that could be subject to full qualitative analysis and be shown to generate realistic dynamic behaviour. The stability of growth and evidence of cycles would be decided through examination of the eigenvalues of the structural parameter matrix, and sensitivity analyses would provide, for example, policy directions for reducing instability or cycle amplitudes. As such, in his early trade cycle model, Bergstrom (1966) specied dierential equations for the logarithms of wages, xed capital, output, consumption and stocks and, for plausible parameter values, found that the model generated a damped 8 year cycle. Bergstrom went on to develop the techniques for estimating such systems, allowing him the opportunity to test his economy-wide macroeconometric models. One of the rst of these was Bergstrom and Wymer (1976) which extended the previously closed models by introducing foreign trade. Although the model failed to generate plausible long run behaviour for the estimated parameter values (an explosive 21 year cycle was observed due to the presence of complex conjugate eigenvalues with positive real parts) it was still the prototype for many continuous time macro-models. Bergstrom, Nowman and Wymer (1992) was a further development with a change in dynamic specication and a change in an important wage equation and Bergstrom (2001) showed that for a range of values of a wage-acceleration parameter, this model was stable, producing dampled cycles. In these systems, factors like technical progress were represented by deterministic trends as was common in models of the time. However, an important advancement in continuous time modelling came with the work on unobserved stochastic trends, which began with Harvey and Stock (1988). Realising the importance of such trend specications, Bergstrom further developed his dynamic models believing that factors like technical progress would be better represented by stochastic rather than deterministic trends. Bergstrom (1997) explicitly dened unobservable stochastic trends with constant drift parameters and incorporated them within a system of dierential equations for observable economic variables. Empirical work on such a model is found in Bergstrom and Nowman (2007) in which plausible long run behaviour is found alongside cycles of length 9 and 40 years, attributed to the trade 2

and Kondratie cycles respectively. This current paper follows closely the unobserved components framework of Harvey and Stock (1993). These models capture the salient time series features observed in real data and hence cyclical behaviour is modelled explicitly, without making heavy use of economic theory as Bergstrom does. This does not preclude a synthesis of the two methodologies though as it may be possible to embed an unobserved cyclical component within a system of dierential equations of observable variables, similar to the stochastic trend in Bergstrom (1997). The unobserved components literature typically considers additive models like trend-plus-cycle, which provide fairly limited interaction between components. With a cyclical trend however, the cyclical element enters explicitly into the trend equation so that the components can be intricately correlated and one can model periodicity in growth rates, whereas the additive model allows trend and cycle to be separate entities. For example, technical progress may be a function of the economys position in the business cycle and hence a cyclical trend would be able to account for this dependence more naturally than an additive model (and indeed would be dicult to capture in a Bergstrom type model without incorporating it as an unobserved component of the type to be presented here). There is limited empirical evidence to suggest which is better suited to modelling economic series or indeed if other specications, like higher-order stochastic cycles1 , are more appropriate. Harvey (1985) however, did nd evidence in favour of a discrete time cyclical trend, over trend-plus-cycle, in four out of ve major U.S. macroeconomic time series and hence for some time series a cyclical trend is indeed more appropriate. As far as the author is aware, the current paper is the rst investigation of cyclical trends in continuous time and it features two alternative cyclical specications, one in the form of a stochastic dierential equation (SDE) as in Harvey and Stock (1993), the other as a dierential-dierence equation (DDE) as in Chambers and McGarry (2002)2 .

2. THE CYCLICAL TREND MODELS Consider y (t) a scalar continuous time process. The cyclical trend model can be specied as y (t) = (t) where d(t) = ( (t) + (t))dt + (dt), d (t) = (dt), t > 0 and (t) ln (t) (dt) = dt + d (t) ln (t) (dt) or d(t) = (a0 (t) + a1 (t l))dt + (dt). 3 (2)

(1)

The trend component (t) includes a stochastic level term (t) as well as the cyclical term (t), which can be of either SDE type as in (1) or of DDE type as in (2). The random
2 dt and 2 dt and are serially measures (dt) and (dt) have zero mean, respective variances

and mutually uncorrelated. The SDE cycle: In (1), is a damping parameter and represents the angular frequency of
2 dt, the cycle. The random measures (dt) and (dt) have zero mean, common variance

are serially and mutually uncorrelated but may be contemporaneously correlated with (dt) and (dt) (denoted dt and dt). The exact discrete time model is yt = t + t where
2 and t is an irregular term3 with variance 1 1

t = t1 + t1 +

s cos(s)dst1 +

s sin(s)ds t1 + t .

(3)

The remaining equations are as in an additive model, i.e. t = t1 + t , t = cos t1 +

sin t1 + t and t = sin t1 + cos t1 + t , where stock variables are given, t 4 t1 (r )dr .

for example, by t = (t) and ows by t =

The unknown parameters that

require estimation are = {, } and up to six distinct elements of the covariance matrices,
2, 2, 2 , , 2 these being and .

The DDE cycle: In (2) the cycle duration is a function of the parameters a0 , a1 and the lag
2 dt and may parameter l. The random measure (dt) again has zero mean and variance

be contemporaneously correlated with (dt) and (dt). The parameters to be estimated are = {a0 , a1 , l} as well as the covariance matrices. At present, no convenient way has been found to express exactly the process generated by a DDE in discrete time, i.e. a model analogous to (3). Therefore frequency domain methods of estimation are required to overcome this issue5 . It is useful to put cyclical trends into context by comparing them with other models in the continuous time literature. A typical alternative to the cyclical trend is the trendplus-cycle model. This would be specied as y (t) = (t) + (t) where d(t) = (t)dt + (dt) is a local linear trend, with (t) and (t) as above with the trend and cycle being independent processes. In structural time series models the component disturbances are often assumed uncorrelated for reasons of identiability (as such correlations are dened in the cyclical trend here, it is acknowledged that this may induce an indentication problem). On the other hand, Bergstroms approach is to formulate a system of stochastic dierential equations, such as dx(t) = Ax(t)dt + (dt) where the vector x(t) contains the levels and derivatives of observable economic variables as well as (t), a trend component given by 4

d(t) = dt + (dt) for a constant drift parameter. Hence the trends are embedded within, and thus help to drive, the structure of the model that generates the economic process. Bergstrom and Nowman (2007) state that for the variables represented by a stochastic trend in their system, a constant drift is appropriate. Harvey and Jaeger (1993) argue in favour of the local linear trend with the possibility of setting the level variance to zero as this produces a smoother trend, which suits some economic time series. It is the authors belief that it is preferable to start with the more general specication, as a more parsimonious alternative will result if zero variances are estimated. When comparing the cyclical specications in (1) and (2) above, it is clear that the SDE enjoys many more favourable properties. It is certainly more intuitive than the DDE as its parameters relate directly to cycle properties like frequency and damping (these must be computed indirectly from complicated functions of the structural parameters with the DDE model). The SDE also benets from the ease with which forecasts can be made and cyclical and trend behaviour can be extracted using Kalman ltering techniques. On the other hand, in his motivation for the use of continuous over discrete time models, Gandolfo (1981) states that the treatment of dynamic economic processes would be better handled using mixed dierential-dierence equations. This is because the adjustment processes of some economic variables require the presence of a lagged variable, maybe a lagged derivative, and hence Bergstrom type dierential equation systems are not appropriate. Examples in economic literature show that quite complex DDEs arise naturally from economic theory, such as De Cesare and Sportelli (2005) who consider an IS-LM system where delayed tax revenues are an important feature with the delay being easily modelled with a lagged variable, or the time-to-build literature in which the gestation period of investment projects plays a major role and again is incorporated using a lag. However, the absence of an exact discrete time model of the DDE is a serious obstacle that limits its usefulness. It is understood that in the dierential equation world, complex eigenvalues in the coecient matrices are the source of the problem for achieving identication and such problems pertain to cyclical time series. Identication problems are therefore likely to be an issue for DDEs like (2), but the lack of an exact discrete time model will prevent a proper analysis of how this manifests itself in these equations. Without an exact discrete model, signal extraction is also more problematic and it is not obvious how to execute such activities without the use of an approximate discretisation. For example, the data generated in the simulations below are from an ARMA approximation of the DDE, observed at short sub-intervals of the unit time interval and such approximations may provide a partial resolution to the 5

problem of extracting components. Specically, the data are generated from the equation 2 ) and h is (t) (t h) = [a0 (t h) a1 (t l h)]h + h(t) where (t) N (0, the length of the sub-interval such that a discrete time stock series is constructed by taking every 1/hth observation and ows are an average over this range of observations. The ner the sub-interval the closer one would be to generating a continuous time series and hence the better the approximation that should result. However, an exact discrete model is crucial for developing methods for forecasting and extracting components if the DDE is to be a comprehensive alternative to the SDE in the unobserved components framework. The aim of the simulation exercise is to assess the eects of (i) cycle specication; (ii) sample size T ; (iii) cycle duration; (iv) cycle damping factor; (v) the correlation between the trend and cyclical random measures, denoted r =

and r =

and (vi)

sampling scheme. All parameters except a0 , a1 , l and are xed, the free parameters being those that determine cycle durations. Specically, 10,000 replications of data are generated with each experiment with sample sizes of T = 64, 128, 256 and 512. Cycles of duration 10 and 40 are considered as cycles of roughly this length (in years) have been observed in the UK economy in the empirical work of Bergstrom and Nowman (2007). To aid a fairer comparison between the SDE and DDE results, the true parameter values have been chosen so that the spectral density functions are similar in terms of their peaks. The spectral densities in Figure 1 are for cycle length 10 where for the SDE spectra = /5 and the height of the peak is determined by , which is xed at 0.9 and 0.85 for the high (labelled A) and low peaks (labelled B) respectively. Empirically these values for seem to be appropriate and although only slightly dierent numerically, the spectral dierence is quite marked. For the DDE, the high (A) and low (B) peak spectra result from respective values = {1, 1.1722, 0.675} and {0.5, 0.7423, 1}. For cycle length 40, = /20 and for the DDE, = {0.75, 0.7885, 1} and {0.2, 0.1868, 1.5} for high and low peaks. The simulation results are provided in Tables 1 and 2 in which the values reported are mean squared errors multiplied by 10,000, for the estimates of { } and {a0 , a1 , l} respectively. It must be borne in mind that the data generated for the SDE experiments are from the exact discrete time model whilst those for the DDE are from an approximation. [Tables 1 and 2 about here] The obvious feature of the tables is that the DDE specication produces results that are more robust to the experiment than the SDE (neither the correlation coecients, sampling scheme nor cycle length have much impact) and oers more uniform behaviour as sample 6

sizes change6 . For the SDE model both the cycle damping and length aect the results and although in most cases the large sample results are good, in smaller samples they are much worse for this set of experiments. It is perhaps to be expected that the low spectral peak, indicating a lesser contribution to the variance of the process made by cycles around that frequency, will aect the estimates of the frequency parameter . The longer cycle causes problems for both SDE and DDE models, although only for the low peak in the DDE case. A cycle of length 40 in a sample of size 64 or 128 will of course be dicult to identify given that very few cycles will be completed, which may explain the poor results. In some cases though, this persists into large samples too, particularly for the low peak experiments. The correlation coecients r and r and sampling scheme have some eect in the SDE case but there seems to be no discernible pattern. An odd feature for long length SDE results is that in some cases the mean squared errors get larger with sample size. In situations where the practitioner knows that the data exhibits an important short length cycle, the SDE will be a preferable specication to use. For the experiments where no correlation exists between the errors of the trend and cyclical components (practitioners would probably restrict the model in this way anyway if only for identiability reasons) then the results are fairly good, although the low peak long length cycle is the worst, particularly for the DDE. For the most part, the DDE parameters are consistently estimated well. For example, 30 years of quarterly data could provide accurate estimates in the presence of a cycle of 2-3 years or about 10 years (length 10 and 40 respectively in Table 2), irrespective of the strength of error correlation or whether the series are stocks or ows. Overall, apart from the obvious problems that occur when the cycle length is long compared to the sample size, the results are encouraging for both specications.

3. CONCLUDING COMMENTS As was indicated in the Introduction, Rex Bergstrom had an interest in formulating models that generate plausible dynamic economic behaviour. Bergstroms models aim to fully specify economic relationships but do not explicitly model features like cycles or seasonality, features that are dealt with eectively in the unobserved components framework. This paper broadens the class of continuous time unobserved components available by allowing for periodicity in growth rates, which is a worthwhile exercise given that there is empirical evidence to suggest that cyclical trends are appropriate for some economic time series. It is clear though that without an exact discrete model the DDE specication for the cycle does not have the qualities to make it a practical alternative to the SDE. However, whilst acknowledging that the approximation used to generate the data may impact on the results, the simulation evidence is encouraging for DDEs and suggests that further research into deriving an exact discrete model would be valuable. Although further identication problems may arise, correlations between trend and cycle disturbances are introduced and for the DDE these appear to make little impact on the accuracy of the estimates, and for scenarios where the practitioner knows that an important short cycle exists in the data, the SDE will estimate it accurately.

Notes
1

In these models cyclical components themselves have periodic innovations, see Harvey and Trimbur

(2003) and Trimbur (2006). The former provides some support that a second-order model is appropriate for U.S. investment.
2

The reader is referred to Chambers and McGarry (2002) for discussion of how DDEs generate cyclical

behaviour and their representation as the cyclical component in additive models.

3 4 5

See Chambers and McGarry (2002) for an explanation of why this is appropriate. Chambers and McGarry (2002) show how to derive the error variance and autocovariance matrices. For details of the estimator and proofs of its asymptotic properties, see Ercolani and Chambers (2006).

The system with SDE cycles could be estimated in the time domain but since one aim of the simulations is to analyse the eects of the cyclical specication, the same estimator is used for fair comparison.
6

The results for some correlation combinations have been excluded from Table 2 as they are very similar

to those presented.

REFERENCES
Bergstrom A.R. (1966) Monetary phenomena and economic growth: a synthesis of neoclassical and Keynesian theories. Economic Studies Quarterly 17, 1-8. Bergstrom A.R. (1997) Gaussian estimation of mixed-order continuous time dynamic models

with unobservable stochastic trends from mixed stock and ow data. Econometric Theory 13, 467-505. Bergstrom A.R. (2001) Stability and wage acceleration in macroeconomic models of cyclical growth. Journal of Applied Econometrics 16, 327-340. Bergstrom, A.R. and K.B. Nowman (2007) A Continuous Time Econometric Model of the United Kingdom with Stochastic Trends. Cambridge University Press. Bergstrom, A.R. & C.R. Wymer (1976) A model of disequilibrium neoclassical growth and its application to the United Kingdom. In A.R. Bergstrom (ed.), Statistical Inference in Continuous Time Economic Models, pp 267-327. North-Holland. Bergstrom, A.R., Nowman, K.B. and C.R. Wymer (1992) Gaussian estimation of a second order continuous time macroeconometric model of the UK. Economic Modelling 9, 313-351. Chambers, M.J. & J.S. McGarry (2002) Modeling cyclical behavior with dierential-dierence equations in an unobserved components framework. Econometric Theory 18, 387-419. De Cesare, L. & M. Sportelli (2005) A dynamic IS-LM model with delayed taxation revenues. Chas, Solitons and Fractals 25, 233-244. Ercolani J.S. & Chambers M.J. (2006) Estimation of dierential-dierence equation systems with unknown lag parameters. Econometric Theory 22, 483-498. Gandolfo, G. (1981) Qualitative Analysis and Econometric Estimation of Continuous Time Dynamic Models. North-Holland. Harvey, A.C. (1985) Trends and cycles in macroeconomic time series. Journal of Business and Economic Statistics 3, 216-227. Harvey, A.C. & A. Jaeger (1993) Detrending, stylized facts and the business cycle. Journal of Applied Econometrics 8, 231-247. Harvey, A.C. & J.H. Stock (1988) Continuous time autoregressive models with common stochastic trends. Journal of Economic Dynamics and Control 12, 365-384. Harvey, A.C. & J.H. Stock (1993) Estimation, smoothing, interpolation and distribution for structural time series models in continuous time. In P.C.B. Phillips (ed.), Models, Methods and Applications of Econometrics: Essays in Honour of A.R. Bergstrom. Blackwell. Harvey, A.C. & T.M. Trimbur (2003) General model-based lters for extracting cycles and trends in economic time series. The Review of Economics and Statistics, 85(2), 244-255. Trimbur, T.M. (2006) Properties of higher order stochastic cycles. Journal of Time Series Analysis 27(1), 1-17.

Table 1: Simulation Results for parameter in the SDE Model

High Peak Cycle Length 10 Sampling Scheme Stocks r 0 0.3 0 -0.6 0 0.3 0 -0.6 0 0.3 0 -0.6 0 0.3 0 -0.6 r 0 0 -0.7 0.1 0 0 -0.7 0.1 0 0 -0.7 0.1 0 0 -0.7 0.1 T = 64 621 785 307 255 1,083 786 783 541 2,473 2,650 6,589 2,708 128 271 5,928 2,198 128 63 36 29 39 38 36 61 40 5,148 2,312 8,526 3,635 57 419 4,835 51 256 15 15 12 14 15 15 12 14 33 2,578 3,284 30 33 37 3,130 30 512 7 7 6 6 7 7 5 6 17 18 46 16 17 217 125 16 T = 64 7,368 8,181 7,035 5,010 3,946 1,035 7,899 3,585 5,484 10,456 19,746 10,498 2,407 2,259 20,084 4,481 Low Peak 128 2,705 624 1,544 950 1,084 86 807 2,817 2,413 2,688 23,546 4,812 89 105 22,193 82 256 40 37 28 37 39 38 28 361 2,454 2,439 18,665 4,748 47 46 20,497 50 512 19 18 13 17 19 18 13 17 15 15 6,305 19 16 15 7,444 20

Flows

40

Stocks

Flows

The entries are mean squared errors multiplied by 104 .

Table 2: Simulation Results for parameters a0 , a1 and l in the DDE Model

High Peak Cycle Length 10 Sampling Scheme Stocks r 0 r 0 a0 a1 l a0 a1 l a0 a1 l a0 a1 l a0 a1 l a0 a1 l a0 a1 l a0 a1 l T = 64 1,886 1,429 1,275 1,845 1,458 1,237 1,838 1,363 1,332 1,731 1,330 1,304 842 721 2,498 827 731 2,311 839 716 2,577 810 710 2,376 128 920 740 466 928 773 466 887 707 474 860 705 477 411 372 936 423 390 913 415 376 970 410 375 959 256 209 173 98 179 153 82 197 161 96 181 155 85 140 128 282 141 131 289 136 125 289 141 131 296 512 2 2 3 2 2 3 2 3 3 3 3 3 8 7 14 6 6 12 8 8 14 7 7 13 T = 64 1,322 705 3,584 1,226 726 3,517 1,290 666 3,755 1,206 683 3,753 14,567 15,551 2,090 26,326 4,536 1,706 11,394 14,042 2,568 6,417 8,625 1,481 Low Peak 128 605 348 1,546 544 361 1,409 593 338 1,580 560 362 1,524 1,281 1,272 633 1,631 1,062 418 1,361 1,226 468 1,207 1,144 412 256 123 84 278 116 90 249 114 80 269 112 87 250 266 403 17 250 31 13 268 251 10 240 263 11 512 6 8 5 5 7 5 6 7 5 5 8 5 39 26 1 51 31 1 40 27 1 55 27 1

-0.6

0.1

Flows

-0.6

0.1

40

Stocks:

-0.6

0.1

Flows:

-0.6

0.1

The entries are mean squared errors multiplied by 104 .

10