The Role of Permanent and Transitory Components in Business Cycle Volatility Moderation

The paper examines the processes underlying economic fluctuations by investigating the volatility moderation of U.S. economy in the early 1980's. We decompose the volatility decline using a dynamic factor framework into a common stochastic trend, common transitory component and idiosyncratic components. We find that the moderation of business cycle was a result of the moderation in transitory and idiosyncratic components. Our results suggest that important part of stochastic process that drives economy is transitory. The paper investigates the role of oil prices, monetary and financial market factors. Proposed economic factors do not have a significant relationship to either transitory or permanent components. In addition, we find that transitory shocks are as common during the 80's and 90's as they were during the 60's and 70's.