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

This paper proposes a systematic framework for analyzing the dynamic effect s of permanent and transitory shocks on a system of n economic variables. W e consider a two-step orthogonolization on the residuals of a VECM with r c ointegrating vectors. The first step separates the permanent from the trans itory shocks, and the second step isolates n - r mutually uncorrelated perm anent shocks and r transitory shocks. The decomposition is computationally straightforward and entails only a minor modification to the Choleski decom position commonly used in the literature. We then show how impulse response functions can be constructed to trace out the propagating mechanism of sho cks distinguished by their degree of persistence. In an empirical example, the dynamic responses to the identified permanent shocks have properties si milar to shocks to productivity, the real interest rate, and money growth, even though no economic theory was used to achieve the identification. We h ighlight two numerical issues that could affect any identification of perma nent and transitory shocks. (C) 2001 Elsevier Science B.V. All rights reser ved.