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Oxford Economic Papers Advance Access originally published online on December 12, 2006
Oxford Economic Papers 2007 59(3):411-429; doi:10.1093/oep/gpl029
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Right arrow C32 - Time-Series Models
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Right arrow E31 - Price Level; Inflation; Deflation
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© Oxford University Press 2006 All rights reserved

Identifying aggregate demand and supply shocks in a small open economy

Walter Enders* and Stan Hurn{dagger}

*Department of Economics, Finance and Legal Studies, University of Alabama, Tuscaloosa, Alabama 35487-0224, USA; e-mail: wenders{at}cba.ua.edu
{dagger}School of Economics and Finance, Queensland University of Technology, Brisbane, Australia; e-mail: s.hurn{at}qut.edu.au


  Abstract

The standard Blanchard-Quah (BQ) decomposition forces aggregate demand and supply shocks to be orthogonal. However, this assumption is problematic for a nation with an inflation target. The very notion of inflation targeting means that monetary policy reacts to changes in aggregate supply. This paper employs a modification of the BQ procedure that allows for correlated shifts in aggregate supply and demand. It is found that shocks to Australian aggregate demand and supply are highly correlated. The estimated shifts in the aggregate demand and supply curves are then used to measure the effects of inflation targeting on the Australian inflation rate and level of GDP.

Key Words: JEL classifications: E3 • C32


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