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Let’s Get Real: A Factor Analytical Approach to Disaggregated Business Cycle Dynamics

Reichlin, L., Forni, M.
Date Published: 01/07/1998

This paper develops a method for analysing the dynamics of large cross-sections based on a factor analytic model. We use “law of large numbers” arguments to show that the number of common factors can be determined by a principal components method, the economy-wide shocks can be identified by means of simple structural VAR techniques and that the parameters of the unobserved factor model can be estimated consistently by applying OLS equation by equation. We distinguish between a technological and a non-technological shock. Identification is obtained by minimizing the negative realizations of the technology shock. Empirical results on 4-digit industrial output and productivity for the U.S. economy from 1958 to 1986 show that: (1) at least two economy-wide shocks, both having a long-run effect on sectoral output, are needed to explain the common dynamics; (2) although the technological shock accounts for at least 50% of the aggregate dynamics of output, it cannot by itself explain dynamics at business cycle frequencies; (3) sector-specific shocks explain the main bulk of total variance but generate mainly high frequency dynamics; (4) both the technological and the non-technological component of output show a peak for positive sectoral comovements of output at business cycle frequencies; (5) technological shocks are strongly correlated with the growth rates of the investment in machinery and equipment sectors and their inputs.

Reichlin, L., Forni, M., "Let’s get real: a factor analytical approach to disaggregated business cycle dynamics", Review of Economic Studies, Volume 65, No. 3, July 1998, pp. 453-73

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