Finance and Economics Discussion Series

Missing Variation in the Great Moderation: Lack of Signal Error and OLS Regression

Jeremy J. Nalewaik
2014-27

Abstract: This paper studies measurement errors that subtract signal from true variables of interest, labeled lack of signal errors (LoSE). The effect on OLS regression of LoSE is opposite the conventional wisdom about classical measurement errors, with LoSE in the dependent variable, not the explanatory variables, causing attenuation bias under some conditions. The paper provides evidence of LoSE in US GDP growth during the period known as the Great Moderation (roughly the mid-1980s to the mid-2000s), illustrating attenuation bias in regressions of GDP growth on asset prices. These biases may have contributed to conventional macroeconomic analysis missing the severity of the adverse shocks hitting the economy in the Great Recession.

Keywords: Measurement error, attenuation bias