A systematic framework for analyzing the dynamic effects of permanent and transitory shocks

Abstract

This paper proposes a systematic framework for analyzing the dynamic effects of permanent and transitory shocks on a system of n economic variables. We consider a two-step orthogonolization on the residuals of a VECM with r co integrating vectors. The first step separates the permanent shocks and r transitory shocks. The approach exploits the co integrating relationships in the data. Although theoretical restrictions can be used, they are not necessary. We also show how impulse response functions can be constructed to trace out the propagating mechanism of shocks distinguished by their degree of persistence. This differs from the common approach of distinguishing shocks by their origin, and hence offers a complementary way of analyzing macroeconomic dynamics.