DP1244 Let's Get Real: A Dynamic Factor Analytical Approach to Disaggregated Business Cycle

Author(s): Mario Forni , Lucrezia Reichlin

Publication Date: September 1995

Keyword(s): Business Cycle , Factor Analysis , Principal Components , Sectoral Movements , Technical Shocks

JEL(s): C51 , E32 , O30

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP1244.asp

This paper analyses output and productivity for 450 US industries from 1958 to 1986. We make the following contributions. (i) We develop a method based on dynamic principal components to identify the number of common shocks to our data set. (ii) We propose a simple method for the estimation of the unobserved common dynamic component in a factor analytic model. (iii) We use a new method for identifying the technology shock based on the innocuous idea that technological innovations are mainly positive. (iv) We propose and construct a measure of the degree of substitution between complementary effects of shocks.Our main empirical findings are: (i) There are only two common shocks driving output and productivity in the 450 sectors; (ii) Technological innovations produce positive comovements at business cycle frequencies, but they are not sufficient to explain all cyclical fluctuations. (iii) Technological shocks are strongly correlated with the growth rates of the investment in machinery and equipment sectors and their inputs.