Common trends and common cycles in per capita GDP: the case of the G7 countries, 1870-2001

In this paper we analyze per capita incomes of the G7 countries using the common cycles test developed by Vahid and Engle (Journal of Applied Econometrics, 8:341-360, 1993) and extended by Hecq et al. (Oxford Bulletin of Economics and Statistics, 62:511-532, 2000; Econometric Reviews, 21:273-307, 2002) and the common trend test developed by Johansen (Journal of Economic Dynamics and Control, 12:231-254, 1988). Our main contribution is that we impose the common cycle and common trend restrictions in decomposing the innovations into permanent and transitory components. Our main finding is permanent shocks explain the bulk of the variations in incomes for the G7 countries over short time horizons, and is in sharp contrast to the bulk of the recent literature. We attribute this to the greater forecasting accuracy achieved, which we later confirm through performing a post sample forecasting exercise, from the variance decomposition analysis.