Interpreting Permanent Shocks to Output When Aggregate Demand May Not Be Neutral in the Long Run

Authors

  • JOHN W. KEATING


  • I thank Pok-sang Lam (the editor) and two referees for very helpful suggestions. I also thank Shigeru Iwata, Robert Rasche, Ellis Tallman, Chris Waller, Tao Zha, and seminar participants at the Atlanta Fed, Purdue University, University of Georgia, University of Kansas, University of Kentucky, University of Missouri, University of Notre Dame, the Econometric Society Summer Meetings, the Midwest Econometrics Group Meeting, the Midwest Macroeconomic Conference, and the Missouri Economics Conference for helpful comments on various earlier versions of the paper. I assume responsibility for any errors and omissions. Support from the General Research Fund at the University of Kansas is gratefully acknowledged.

  • John W. Keating is an associate professor at the University of Kansas (E-mail: jkeating@ku.edu).

Abstract

This paper studies a popular statistical model of permanent and transitory shocks to output using a set of arguably more plausible structural assumptions. One way to structurally interpret the model is by assuming aggregate demand has no long-run output effect. However, many economic theories are inconsistent with that assumption. Instead, we reinterpret the statistical model assuming a positive shock to aggregate supply lowers the price level and in the long run raises output while a positive shock to aggregate demand raises the price level. Under these assumptions, a puzzling finding from the empirical literature implies that a positive aggregate demand shock had a long-run positive effect on output in pre–World War I economies.

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