A Macro-Fiscal Modeling Framework for Forecasting and Policy ...

Chapter 2
STATIONARITY AND STRUCTURAL BREAKS: SELECTED MACRO
AGGREGATES
In this Chapter, we discuss issues related to stationarity of macro economic time series.
In the literature, the importance of determining whether a time series is difference
stationary or trend-stationary has been much emphasized. If a series is difference
stationary, the appropriated modeling methodology would be cointegration with error
correction. If a series is trend-stationary, the conventional methodology of specification
and estimation would be relevant. In recent literature, macro economic series are often
found to be trend-stationary with one or more structural breaks. Identifying the timing of
such structural breaks therefore becomes quite important.
With the publication of the seminal paper by Nelson and Plosser (1982) on
“Trends and Random Walks in Macroeconomic Time Series”, an extensive debate was set
in motion whether most macroeconomic series were trend-stationary or differencestationary.
The latter category of series is characterized by a unit root. Nelson and
Plosser themselves had concluded that most of the important US macroeconomic series
including GNP, prices, employment and interest rate were I(1) variables; that is, they
contained a unit root. The presence of unit roots rendered many existing estimations of
economic relationships spurious. It also led to one body of literature focused on
decomposing macro series between permanent and cyclical components. The permanent
component indicates the persistence of macroeconomic shocks. Nelson and Plosser's
study was followed by a series of empirical analyses which basically confirmed their
findings. Stulz and Wasserfallen (1985) and Wasserfallen (1986), Dickey-Fuller (1979)
among others applied a similar statistical methodology to other economic series.
Some other important contributions relating to this topic are Campbell (1986),
Mankiw (1987), Cochrane (1988), Diebold and Rudenbusch (1989) for univariate contexts
and Shapiro and Watson (1988) and Blanchard and Quah (1989) for multivariate
contexts. The attempts to decompose GNP and money supply series between permanent
and cyclical components also led to a considerable theorizing of particularly, business
cycles of real business cycles theory (see King and Plosser, 1984).
Another direction in which the literature evolved related to cointegration and
error correction models that were initiated with the seminal work of Engle and Granger
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