A Simple Correction for Misspecification in Trend-Cycle Decompositions with an Application to Estimating r*

James Morley, Trung Duc Tran and Benjamin Wong

CAMA Working Papers from Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University

Abstract: We propose a simple correction for misspecification in trend-cycle decompositions when the stochastic trend is assumed to be a random walk process but its estimated path displays serial correlation in its first differences. Possible sources of this misspecification, which might otherwise be hard to detect, include unaccounted for measurement error in the data, omitted variables, or incorrect assumptions about dynamics in the original model used to estimate trend. Our proposed correction is conducted via application of a univariate Beveridge-Nelson decomposition to the preliminary estimated trend and we show in Monte Carlo analysis that this approach can work as well as if the model used to estimate trend were correctly specified. We demonstrate the empirical relevance of our proposed correction in an application to estimating the trend path of the short-term risk-free real interest rate, r* (a.k.a. “r*-star†). Our corrected estimate of r* is considerably smoother than the preliminary estimate from a multivariate Beveridge-Nelson decomposition based on a vector error correction model, consistent with the presence of measurement error in at least some of the variables in the model.

Keywords: trend-cycle decomposition; misspecification; natural rate of interest (search for similar items in EconPapers)
JEL-codes: C13 C53 E43 (search for similar items in EconPapers)
Pages: 58 pages
Date: 2022-01, Revised 2023-03
New Economics Papers: this item is included in nep-mac
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Citations: View citations in EconPapers (2)

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https://cama.crawford.anu.edu.au/sites/default/fil ... vised_march_2023.pdf Revised Version (application/pdf)
https://cama.crawford.anu.edu.au/sites/default/fil ... an_wong_jan_2022.pdf Original Version (application/pdf)

Related works:
Journal Article: A Simple Correction for Misspecification in Trend-Cycle Decompositions with an Application to Estimating r* (2024)
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Persistent link: https://EconPapers.repec.org/RePEc:een:camaaa:2022-02

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