Permanent and Transitory Macroeconomic Relationships between China and the Developed World

The relationships between the economic fluctuations of the US and China, the largest developed and developing countries respectively, are very important not only to both countries but also to the world economy. This paper applies a two-country correlated unobserved components model to explore the relationships between the real output fluctuations for the US and China over the period 1978q1-2008q4. The model allows us to distinguish cross-country correlations driven by permanent movements, caused by real shocks such as changes in technology and institutions, from those due to transitory movements. We find that the two countries share approximately half of their permanent and transitory shocks. With information from the real output of China, the magnitude of estimated transitory components fluctuations of the US real GDP is larger, while the transitory component of China’s real GDP does not change much with the addition of US information and other alternative external information sets such as real GDP of Hong Kong as well.