Identifying Aggregate Demand and Supply Shocks in a Small Open Economy
- Resource Type
- research-article
- Authors
- Enders, Walter; Hurn, Stan
- Source
- Oxford Economic Papers, 2007 Jul 01. 59(3), 411-429.
- Subject
- E3
C32
Supply shocks
Aggregate demand
Demand shocks
Aggregate supply shocks
Inflation targeting
Vector autoregression
Standard deviation
Aggregate supply
Supply
Supply and demand
- Language
- English
- ISSN
- 00307653
14643812
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.