Working Paper No. 13
By Gabriel Sterne and Tamim Bayoumi
Structural vector autoregressions (VARs) are used to distinguish between transitory (aggregate demand) disturbances to output and permanent (aggregate supply) disturbances. The results indicate that the two disturbances are of roughly equal importance in explaining fluctuations in growth and inflation across a wide range of OEeD countries. This implies that economic fluctuations cannot be characterised as cyclical fluctuations around a fixed trend (the Keynesian synthesis view) or as continual movements in underlying supply potential (a view of real business cycle theorists), but as an amalgam of both effects. A method of distinguishing the effects of each type of disturbance on output and prices is then outlined. This makes it possible to measure 'supply potential' for each economy; we find evidence of a steady decline in the rate of increase of supply potential over time, a view consistent with the 'catch up' theory of post-war economic growth.