Common Dynamics Between the US and Puerto Rican

Economies

César R. Sobrino
School of Business & Entrepreneurship
University of Turabo
PO BOX 3030
Gurabo, PR 00778
Email: sobrinoc1@suagm.edu

ABSTRACT

In this paper, I examine the comovements between the US real gross domestic product (RGDP)
and the Puerto Rican RGDP. To accomplish this, I employ a cointegration test and the Vahid and
Engle (1993)’s common feature test. Using data from 1947 to 2008, the findings indicate there
are common movements between Puerto Rico and the US in the long and short run. Likewise, the
evidence shows that Puerto Rico has been more sensible to US permanent shocks than US
transitory shocks.

En este documento, analizo los movimientos comunes entre el PBI real de Estados Unidos y el
PBI real de Puerto Rico. En este cometido, utilizo un test de cointegración, así como, el test de
Vahid&Engle(1993) sobre movimientos cíclicos comunes. De 1947 al 2008, los resultados
indican que Estados Unidos y Puerto Rico presentan una tendencia y fluctuaciones cíclicas
comunes. Además, se encuentra que Puerto Rico ha sido más sensible a los choques permanentes
provenientes de Estados Unidos que a los choques transitorios que provinieron del mismo país.

Keywords: Time Series Models, Macroeconomics, Business Cycles,

JEL Classification: C32, E20, E32

1. Introduction

Puerto Rico is a self-governing non-incorporated territory of the United States and its

economy works under the US legal frame: the American dollar is the legal tender on the

island; there is a common customs union; and there are no factor mobility restrictions.

According to the economic literature, these characteristics determine the common

movements between the two economies.

In this paper, I analyze the comovements between the US and Puerto Rico following the

techniques employed by Herrera (2003), who tested the comovements between US and

Mexico after the adoption of the North American Free Trade Agreement (NAFTA). The

stages of this scheme are: (1) identify a long-term relationship between the US real gross

domestic product (RGDP; QUS) and the Puerto Rican RGDP (QPR) using a cointegration

test; and (2), conditional to cointegration, find a short-run relationship between both

RGDPs using Vahid and Engle (1993)’s test. This approach is different from that

employed by Alameda (2000), who examines the Puerto Rican business cycles.

Using annual data (1947–2008), the evidence indicates that the two economies share a

common trend. Moreover, QPR has positively responded by almost 4% to a 1% increase

in US permanent shocks. This finding is consistent with the fact that, in 1950–2007, the

RGDP per capita of Puerto Rico grew by almost eight times, while the US RGDP per

capita grew by almost three times. Likewise, both economies share common cycles, and

QPR has positively responded by almost 1.6% to a 1% increase in US transitory shocks.

However, this last outcome needs more revision because Puerto Rico’s RGDP is just

accounted annually for and with some delay, which would mislead short-run outcomes.

2
This paper is organized as follows: Section 2 presents a brief review of the econometric

techniques used and some empirical findings. Section 3 presents the cointegration and

common cycle tests and data; section 4 reports the outcomes of the tests; and section 5

concludes.

2. Literature Review and Empirical Findings

Cointegration (Engle and Granger, 1987; Stock and Watson, 1988; Johansen, 1991)

examines the existence of common stochastic trends among non-stationary time series. In

a bivariate case, two time series of order p are cointegrated when there is at least one

linear combination of them of the order p-1. Likewise, conditional to cointegration, the

common feature test (Vahid and Engle, 1993) examines common cycles among times

series. In this case, the matrix of cointegrating parameters is used to determine the

existence of short-run comovements

Engle and Kozicki (1993) analyze common features among stationary time series.

In this approach, the common feature test is not conditional to cointegration and the

comovements are assumed to be exactly synchronized. In addition, Vahid and Engle

(1997) extend Engle and Kozicki’s approach in analyzing common features when they

are not synchronized. These movements are called “codependent cycles.” These two

approaches focus on short-run common movements.

For Brazil and Argentina, which are major trading partners, Engle and Issler

(1993), Arnaudo and Jacobo (1997), and Mejía (1999, 2000) have found that the

countries share strong comovements. For Mexico and the US, which are also major

trading partners, Mejía, (1999, 2000) finds common cycles between both countries from

1950 through 1995. However, using a different sample, Torres (2000) only shows strong

3
evidence of common cycles from 1948 to 1979. Finally, Herrera (2004) found that, after

NAFTA adoption, both countries have shared a common trend and common cycles.

3. Cointegration and Cofeature Tests and Data

Consider n variables of integration order I(1), which can be represented in the next VAR

in the reduced form of order p+1:

,…..(1)

where x is an (n*1) column vector of time processes; is an (n*1) column vector of

deterministic variables; is an (n*n) matrix of coefficients of ; Ai is an (n*n) matrix of

coefficients with elements Ajk (i); and ε is the (n*1) matrix of disturbance terms

( where Ω is the (n*n) variance-covariance matrix). Suffix t stands for time.

After some operations of adding and subtraction in (1), the following VECM of order p it

is obtained:

,…(2)

where , , and Δ is the first difference operator.

Johansen (1991)’s cointegration test focuses on the rank (r) of π. If 0 < r < n, there are r

linear combinations of the series, which are I(0). In other words, r is the number of

cointegrating vectors. Likewise, VAR is used in the first differences when r = 0.

Moreover, if r = n, it means that xt is I(0).

To find r, Johansen (1991) presents two tests statistics:

and . T is the number of usable

4
observations and the lambdas are the eigenvalues of π. In the first test, the null hypothesis

is the number of cointegrating vectors ≤ r, and in the second test, the null hypothesis is

the number of cointegrating vectors = r.

In addition, Johansen (1991) decomposes π into two matrices, α and β ( ), to test

the restrictions in the cointegrating vector. β is the (n*r) matrix of cointegrating

parameters and α is the (n*r) matrix of speed of adjustment parameters.

Once a long-term relationship is found among the series, the cointegrating vector is used

to find Vahid and Engle (1993)’s statistics for the common cycles test. In this approach,

the canonical correlations between {Δxt} and { xt-1, Δxt-1,…,Δxt-p} are estimated. The null

hypothesis that the dimension of the cofeature space is at least s (the quantity of the

smallest squared canonical correlations) is tested with this statistic. The statistic

is , where ’s (i=1,2,3,..,s) are the smallest

squared canonical correlations. This statistic has a Chi-square distribution with s(np+r)-

s(n-s) degrees of freedom.

5
3.1. Data and Modeling

For the period 1947–2008 (yearly data), the US RGDP, hereafter QUS, is provided by the

Fed of St. Louis web page, while the Puerto Rico Planning Board provides the RGDP for

Puerto Rico,1 hereafter QPR. Thus, n=2. In Figure 1, both series are shown in logs. At first

glance, over the 60 year period, it looks like they share a common trend and short-run

comovements (mostly in the 1970s); however, after the 2001 US recession, it seems that

both processes meander away from one another.

In order to determine the integration order of the series, Augmented Dickey-Fuller test’s

outcomes are used; the results are shown in Table 1. They indicate that neither process is

stationary because the null hypothesis cannot be rejected. In the first differences, the null

hypothesis, which is that the process has a unit root, is rejected at 5% of significance for

both series. This indicates that both RGDPs are I(1).

To test the optimal lag order of the VAR, the Akaike Information Criterion (AIC) is

employed; the results are reported in Table 2. They indicate that the optimal lag order at

levels is 3, which means that the optimal lag order is 2 in the first differences. Thus, when

p=2, (2) has the following form:

Including in the former, the model employed in this paper is:

, ……(3)

1
I thank Dr. Ervin Martinez, Director of the Puerto Rico Planning Board, for making the Puerto Rican data
available.

6
Where L is a matrix of lag operators and . The number of

usable observations is 62 (=T).

In this form, the matrix of deterministic variables allows changes regarding the inclusion

of unrestricted and restricted constants, as well as unrestricted and restricted linear trends.

If there is a restricted constant or a restricted linear trend, α is part of its coefficient. In

other words, the coefficients of the restriction are included in the cointegrating vector.

Once a cointegrating relationship is established, given p=2, the canonical correlations

between {Δxt} and { xt-1, Δxt-1} have to be computed. The statistic is

, where i=1,2, and there are s(2+r)-s(2-s) degrees of freedom for

all s>0.

4. Outcomes

Including a drift and a restricted linear trend, the outcomes of λtrace and λmax tests are

shown in Table 3 and Table 4, respectively. In the first test, the null hypothesis that r≤1

cannot be rejected at 5% significance, while the null hypothesis that r=0 is rejected at 5%

significance. In the second test, the null hypothesis that r=0 is rejected at 10% and the

null hypothesis that r=1 cannot be rejected at 5% significance. All of these results

indicate that there is at most one cointegrating relationship between QUS and QPR over the

long run. In other words, they share a common trend.

When it is not included as a restricted trend, in both lambda tests, the null hypothesis that

r=0 cannot be rejected. The restricted linear trend is consistent with data showing that the

two RGDPs veer apart after the 2001 US recession. Likewise, QPR does not show any

breaks; for that reason, no dummy has been included. However, to be accurate, (1) is run

7
including a time dummy (1991–2009=1; otherwise, zero). This dummy is not significant

at 5%.2

β is (1, -0.22, -0.02), normalized with respect to the coefficient of QUS. The second one is

the cointegrating coefficient of QPR, and the last one is the coefficient of the linear trend.

The restricted α is (-0.56,-0.36), which means that when both series (or one of them)

deviate from their long run equilibrium, the adjustment of QUS is faster than the

adjustment of QPR.

On the other hand, in order to get the canonical correlations, the cointegrating restriction

(β) is used to test common cycles. Reported in Table 5, this test indicates that there is a

common feature between QUS and QPR. The null hypothesis that s>0 cannot be rejected at

5% significance, and the null hypothesis that s>1 is rejected at 5% significance.

Both the cointegrating and cofeature vectors are shown in Table 6. Puerto Rico is more

sensible to US permanent shocks than US temporary shocks. Specifically, QPR positively

responds at almost 4% to a 1% change in US permanent shocks in the long run. This

outcome is consistent with the fact that, from 1950 to 2007, the RGDP per capita of

Puerto Rico has grown by almost eight times while the US RGDP per capita has grown

by three times.3

2
For Puerto Rico, Alameda (2000) divides his analysis into two periods: 1967:01–1991:03 and 1991:03–
1998:06. Using a Chow test and the Economic Activity Index as a proxy variable of real GDP, He finds
that there is a break in 1991:03.
3
The Puerto Rico RGDP per capita was $3,327.01 in 1950, and $26,212.98 in 2007; the US RGDP per
capita was 12,989.94 in 1950, and 42,886.92 in 2007 (Penn Tables 6.3).

8
In the short run, QPR positively responds at almost 1.6% to a 1% change in US transitory

shocks.4 Alameda (2000) finds that, since the late 1980s, US transitory shocks have been

diminishing in terms of their importance for Puerto Rican RGDP fluctuations. However,

this last result needs more revision because the Puerto Rico RGDP is just determined

annually and with some delay,5 which would mislead short-run outcomes.

5. Conclusions

The outcomes presented in this paper show that Puerto Rico is more sensible to US

permanent shocks than US temporary shocks. Specifically, QPR positively responds at

almost 4% to a 1% change in US permanent shocks in the long run. In the short run, QPR

positively responds at almost 1.6% to a 1% change in US transitory shocks.

The long-run results are consistent with the increase of RGDP per capita in Puerto Rico

over the 60-year period. However, in Puerto Rico, regrettably, only the annual GDP is

determined and this frequency does not accurately describe short-run fluctuations as is

the case with quarterly data. In addition, another shortcoming is that the annual GDP in

Puerto Rico is accounted for from July to June, while the US GDP is accounted from

January to December. Evidently, the Puerto Rican GDP is reported with some delay.

Some attention should be focused on reviewing short-run outcomes through an

analysis of the comovements of the Economic Activity Indexes. Measured by the

Conference Board in the US and the Government Development Bank in Puerto Rico,

4
In contrast, after 1993 (when NAFTA was adopted), as reported by Herrera (2004), the Mexican RGDP
became less sensible to US permanent shocks than US transitory shocks. In the first case, the real output
increased by less than 1% in response to a 1% rise in US permanent shocks. In the second case, the real
output increased by almost 4% in response to a 1% change in transitory shocks.
5
Bram, J., F. Martinez, and C. Steindel (2008).

9
these indexes are recorded monthly on the basis of the construction, manufacturing, and

service sectors, as well as job growth and consumer outlays. Thus, these indexes might be

useful to short run co-features between both countries, because they accurately account

for short-run fluctuations. In this sense, Engle and Kozicki (1993) and Vahid and Engle

(1997)’s techniques are useful tools for the forthcoming analysis.

10
References

Alameda, J. (2000) “Globalización, Ciclos Económicos y Respuesta Cíclica de la

Economía de Puerto Rico: Evidencia Empírica entre 1967 a 1998,” Unidad de
Investigaciones Económicas, Departamento de Economía, Universidad de Puerto Rico,
Río Piedras, Feb, #3.

Arnaudo, A., and A. Jacobo (1997) “Macroeconomic Homogeneity within Mercosur: An

Overview,” Estudios Economicos 12, pp. 37-51.

Bram, J., F. Martinez, and C. Steindel (2008) “Trends and Developments in the Economy
of Puerto Rico,” New York Federal Reserve, Current Issues 14(2).

Engle, R., and J. Issler (1993) “Common Trends and Common Cycles in Latin America,”
Revista Brasileira de Economia 47, pp 149-176.

Engle, R., and S. Kozicki (1993) “Testing for Common Features,” Journal of Business
and Economic Statistics 11, pp. 369-396.

Engle, R., and C. Granger (1987) “Cointegration and Error Correction: Representation,
Estimation and Testing”, Econometrica 55, pp 251-276.

Herrera, J. (2004). “Business Cycles in Mexico and the United States: Do they share
common movements?” Journal of Applied Economics, 7(2), pp. 303-323.

Johansen, S. (1991) “Estimation and Hypothesis Testing of Cointegration Vectors in

Gaussian Vector Autoregressive Models,” Econometrica 59, pp. 1551-1580.

Mejia, P. (1999) “Classical Business Cycles in Latin America: Turning Points,

Asymmetries and International Synchronization,” Estudios Economicos 14, pp. 265-297.

Mejia, P. (2000) “Asymmetries and Common Cycles in Latin America: Evidence from
Markov Switching Models,” Economia Mexicana 9, pp. 189-225.

Torres, A. (2000) “Estabilidad en Variables y el Ciclo Economico: El Caso de Mexico,”

Documento de Investigacion 2000, 03, Banco de Mexico.

Vahid, F., and R. Engle (1993) “Common Trends and Common Cycles,” Journal of
Applied Econometrics, 8, pp. 341-360.

Vahid, F., and R. Engle (1997) “Codependent Cycles,” Journal of Econometrics 80, 199-
221.

11
 Figure 1: US RGDP vs. Puerto Rico RGDP
(1947-2008)
30.5
24

30.0

23
29.5

22
29.0

21 28.5

28.0
20
50 55 60 65 70 75 80 85 90 95 00 05

US RGDP in logs (right-hand side)

PR RGDP in logs (left-hand side)

Shadow bars indicate US recessions

12
Table 1: Unit Root Test (ADF)
Null Hypothesis P-value

Log of QUS has a unit root 0.5211

Log of QPR has a unit root 0.9836

QUS growth rate has a unit root 0.0413

QPR growth rate has a unit root 0.0376

At levels: 10 lags, including intercept and trend.

In first differences, 5 lags without intercept and trend.

Table 2: Optimal Lag Order-VAR

lags AIC

1 -9.50551
2 -9.6399
3 -9.64575*
4 -9.55505
5 -9.46928

* indicates the minimal value.

13
Table 3: Johansen's Trace Test (restricted trend)
Null Hypothesis: # of Trace Critical Value at
Eigenvalue P-value
cointegrating vectors Statistic 5%

r=0 0.31006 26.84242 25.87211 0.0378

r≤1 0.08039 4.944535 12.51798 0.6044

Table 4: Johansen's Max Test (restricted trend)

Null Hypothesis: # of Max-Eigen Critical Value
Eigenvalue P-value
cointegrating vectors Statistic at 5%

r=0 0.31006 21.89788 19.38704 0.0212

r=1 0.08039 4.944535 12.51798 0.6044

Table 5: Test of Common Cycles

Null Hypothesis: # Critical Value
Canonical Vahid and Engle's
of common
Correlations (1993) Statistics (DF)
features at 5% (P-value)
s >1 0.6025 16.38 (8) 15.51 (0.0181)
s >0 0.4468 5.42 (2) 5.99 (0.0665)

Table 6: US Real GDP and Puerto Rico Real GDP Common Dynamics
Long Run
Normalized cointegrating vector (β)
log(QUS) log(QPR) TREND
1 -0.22 -0.02
(-0.03027) (-0.00149)

Short Run
Normalized common feature vector( )
Δlog(QUS) Δlog(QPR)
1 -0.53
(-0.1985)

Standard deviations in parentheses

14