Interpreting Permanent and Transitory Shocks to Output When Aggregate Demand May Not Be Neutral in the Long-run

Abstract

I examine the statistical model of permanent and transitory shocks to output under the following structural assumptions: An aggregate supply shock that raises output will cause the price level to fall and an aggregate demand shock that initially raises output will cause the price level to rise. No assumption is made about the long-run effect of aggregate demand on output. Based on these assumptions I obtain three primary results. First, if a permanent increase in output is associated with an increase in the price level, then aggregate demand shocks have a positive long-run effect on output. Second, the output variance explained by permanent shocks exceeds the variance attributable to aggregate supply when aggregate demand shocks have a positive effect on output in the long run. Third, permanent and transitory shocks will affect price and output in qualitatively the same way as aggregate supply and aggregate demand shocks, respectively, from textbook macro theory over a range of values for the structural parameter describing the long-run effect of aggregate demand on output. These results are used to explain and interpret empirical findings from the literature and to motivate directions for future researchvector autoregression, identification restriction, permanent and transitory shocks, supply and demand shocks