American Economic Association 7KH'\QDPLF(IIHFWVRI$JJUHJDWH'HPDQGDQG6XSSO\'LVWXUEDQFHV $XWKRU V 2OLYLHU-HDQ%ODQFKDUGDQG'DQQ\4XDK 6RXUFH7KH$PHULFDQ(FRQRPLF5HYLHZ9RO1R 6HS SS 3XEOLVKHGE\$PHULFDQ(FRQRPLF$VVRFLDWLRQ 6WDEOH85/http://www.jstor.org/stable/1827924 $FFHVVHG Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/action/showPublisher?publisherCode=aea. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact [email protected]. American Economic Association is collaborating with JSTOR to digitize, preserve and extend access to The American Economic Review. http://www.jstor.org The Dynamic Effects of Aggregate Demand and Supply Disturbances By OLIVIER JEAN BLANCHARD AND DANNY QUAH* We interpret fluctuations in GNP and unemployment as due to two types of disturbances: disturbances that have a permanent effect on output and distur- bances that do not. We interpret the first as supply disturbances, the second as demand disturbances. Demand disturbances have a hump-shaped mirror-image effect on output and unemployment.The effect of supply disturbances on output increases steadily over time, peaking after two years and reaching a plateau after five years. It is now widely accepted that GNP is However, if GNP is affected by more than reasonably characterized as a unit root pro- one type of disturbance, as is likely, the cess: a positive innovation in GNP should interpretation becomes more difficult. In that lead one to revise upward one's forecast on case, the univariate-moving average repre- GNP for all horizons. Following the influ- sentation of output is some combination of ential work of Charles Nelson and Charles the dynamic response of output to each of Plosser (1982), this statistical characteriza- the disturbances. The work in Stephen tion has been recorded and refined by nu- Beveridge and Nelson (1981), Andrew Har- merous authors including John Campbell and vey (1985), and Watson (1986) can be viewed N. Gregory Mankiw (1987a), Peter Clark as early attempts to get at this issue.' (1987, 1988), John Cochrane (1988), Francis To proceed, given the possibility that out- Diebold and Glenn Rudebusch (1988), put may be affected by more than one type George Evans (1987), and Mark Watson of disturbance, one can impose a priori re- (1986). strictions on the response of output to each How should this finding affect one's views of the disturbances, or one can exploit infor- about macroeconomic fluctuations? Were mation from macroeconomic variables other there only one type of disturbance in the than GNP. In addition to the work named economy, then the implications of these above, Clark (1987) has also used the first findings would be straightforward. That dis- approach. This paper adopts the second, and turbance would affect the economy in a way considers the joint behavior of output and characterized by estimated univariate-mov- unemployment. Campbell and Mankiw ing average representations, such as those (1987b), Clark (1988), and Evans (1987) have given by Campbell and Mankiw. The prob- also taken this approach. Our analysis differs lem would simply be to find out what this mainly in its choice of identifying restric- disturbance was, and why its dynamic effects had the shape that they did. The way to proceed would be clear. 'As will become clear, our work differs from these in that we wish to examine the dynamic effects of distur- *Both authors are with the Economics Department, bances that have permanent effects; such issues cannot MIT, Cambridge MA 02139, and the NBER. We thank be addressed by studies that restrict the permanent Stanley Fischer, Julio Rotemberg, Mark Watson for component to be a random walk. In other work, one of helpful discussions, and the NSF for financial assis- us has characterized the effects of different parametric tance. We are also grateful for the comments of two specifications (such as lag length restrictions, a rational anonymous referees and of participants at an NBER form for the lag distribution) for the question of the Economic Fluctuations meeting, and for the hospitality relative importance of permanent and transitory com- of the MIT Statistics Center. ponents. See Ouah (1988). 655 656 TIIE AMERICAN ECONOMIC REVIEW SEPTEMBER 1989 tions; as we shall argue, we find our restric- variance decompositions of output at various tions more appealing than theirs. horizons, we find that the respective contri- Our approach is conceptually straightfor- butions of supply and demand disturbances ward. We assume that there are two kinds of are not precisely estimated. For instance, at disturbances, each uncorrelated with the a forecast horizon of four quarters, we find other, and that neither has a long-run effect that, under alternative assumptions, the con- on unemployment. We assume however that tribution of demand disturbances ranges the first has a long-run effect on output while from 40 percent to over 95 percent. the second does not. These assumptions are The rest of the paper is organized as fol- sufficient to just identify the two types of lows. Section I analyzes identification, and disturbances, and their dynamic effects on Section II discusses our economic interpreta- output and unemployment. tion of the disturbances. Section III dis- While the disturbances are defined by the cusses estimation, and Section IV charac- identification restrictions, we believe that terizes the dynamic effects of demand and they can be given a simple economic inter- supply disturbances on output and unem- pretation. Namely, we interpret the distur- ployment. Section V characterizes the rela- bances that have a temporary effect on out- tive contributions of demand and supply put as being mostly demand disturbances, disturbances to fluctuations in output and and those that have a permanent effect on unemployment. output as mostly supply disturbances. We present a simple model in which this inter- I. Identification pretation is warranted and use it to discuss the justification for, as well as the limitations In this section, we show how our assump- of, this interpretation. tions characterize the process followed by Under these identification restrictions and output and unemployment, and how this this economic interpretation, we obtain the process can be recovered from the data. following characterization of fluctuations: We make the following assumptions. There demand disturbances have a hump-shaped are two types of disturbances affecting un- effect on both output and unemployment; employment and output. The first has no the effect peaks after a year and vanishes long-run effect on either unemployment or after two to three years. Up to a scale factor, output. The second has no long-run effect on the dynamic effect on unemployment of de- unemployment, but may have a long-run mand disturbances is a mirror image of that effect on output. Finally, these two distur- on output. The effect of supply disturbances bances are uncorrelated at all leads and lags. on output increases steadily over time, to These restrictions in effect define the two reach a peak after two years and a plateau disturbances. As indicated in the introduc- after five years. "Favorable" supply distur- tion, and discussed at length in the next bances may initially increase unemployment. section, we will refer to the first as demand This is followed by a decline in unemploy- disturbances, and to the second as supply ment, with a slow return over time to its disturbances. How we name the disturbances original value. however is irrelevant for the argument of While this dynamic characterization is this section. fairly sharp, the data are not as specific as to The demand and supply components de- the relative contributions of demand and scribed above are permitted to be serially supply disturbances to output fluctuations. correlated. Under regularity conditions, each On the one hand, we find that the time-series of these components can always be uniquely of demand-determined output fluctuations, represented as an invertible distributed lag that is the time-series of output constructed of serially uncorrelated disturbances. Thus, by putting all supply disturbance realiza- we can refer to the associated serially uncor- tions equal to zero, has peaks and troughs related disturbances as the demand and sup- which coincide with most of the NBER ply disturbances themselves: this is without troughs and peaks. But, when we turn to ambiguity or loss of generality. We will then VOL. 79 NO. 4 BLANCHARD AND QUAH: DEMAND AND SUPPLY DISTURBANCES 657 also require a further technical condition: tation: the innovations in the bivariate Wold de- composition of output growth and unem- (2) X(t) = v(t)+ C(1)v(t-1)+ ployment are linear combinations of these underlying demand and supply disturbances. 00 We now derive the joint process followed = L C(j)v(t-j), by output and unemployment implied by j=0 our assumptions. Let Y and U denote the logarithm of GNP and the level of the unem- Var(v) = Q. ployment rate, respectively, and let ed and eS be the two disturbances.