Asymmetry in the Business Cycle: Friedman's Plucking Model with Correlated Innovations

Tara M. Sinclair, George Washington University

Abstract

This paper develops an unobserved components model for U.S. real GDP that allows for both asymmetric transitory movements and correlation between the permanent and transitory innovations. The asymmetry is modeled using Markov-switching in the transitory component in the spirit of Kim and Nelson's (1999) version of Friedman's plucking model. The findings suggest that ignoring the correlation between permanent and transitory movements underestimates the role of permanent movements, whereas ignoring asymmetry in the transitory component underestimates the role of temporary movements in U.S. real GDP. These results imply that both permanent movements and asymmetric transitory shocks are important for explaining post-war output fluctuations in the U.S. and for explaining the recession that began in 2007 in particular.