Aggregate Supply and Demand Shocks: A Natural Rate Approach

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Research Papers

Aggregate Supply and Demand Shocks: A Natural Rate Approach

December 1997 Number 9739

Author: Arturo Estrella

There is wide agreement that the dynamics of inflation and unemployment are influenced by supply and demand shocks, such as oil price and monetary policy surprises, and by systematic factors such as overlapping contracts. There is less agreement about the relative importance of those determinants. The natural rate model of this paper uses a structural VAR approach to decompose movements in U.S. postwar unemployment and inflation into three orthogonal components. These components correspond, respectively, to systematic or predictable changes, supply shocks, and demand shocks. Orthogonality facilitates the detailed analysis of the individual components. Specifically, supply and demand shocks are shown to be correlated with observable variables in sensible ways, and they are used to analyze and interpret inflation-unemployment tradeoffs and postwar business cycles. In addition, the systematic component of inflation, which is equivalent to a NAIRU gap, is shown to predict changes in inflation reasonably well over a one-year horizon.

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