DP4244 | The HP-Filter in Cross-Country Comparisons

Publication Date

23/02/2004

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Abstract

Many empirical studies have applied the Hodrick-Prescott filter in cross-country comparisons of business cycle fluctuations. The Hodrick-Prescott filter involves the smoothing parameter l, and standard practice in the literature is to set this parameter equal to 1600 (in quarterly data) for all countries. We show that this choice might distort the results when the cyclical component is highly serially correlated, and that care should be taken in checking if the results are unreasonable in the light of common wisdom. For example, for Spanish data we show that, contrary to conventional wisdom, the results imply that the Spanish cycle is very smooth and that the period of 1975-85 was one of macroeconomic tranquility. We propose to recast the HP-filter as a constrained minimization problem, which selects endogenously a value of l that imposes cross-country consistency of the imposed constraint. Our proposed method is easy to apply and retains all the virtues of the standard HP-filter. When applied to Spanish data, the results imply a return to conventional wisdom and we find results in line with economic historian?s views. We also examine data for a number of OECD countries and find that, with the exception of Spain, Italy and Japan, the standard choice of l = 1600 is sensible.