The Boom and the Depression: A Note on the Identification of Aggregate Supply Shocks

Introduction

This short paper is a straightforward continuation of Sauramo (1998). The aim of that paper was to analyse the boom of the late eighties and the depression of the early nineties by estimating structural VAR models which were based on the utilization of the traditional aggregate demand aggregate supply framework. These models typically belong to the class of IS-LM models which have been augmented with a Phillips curve.

A large number of recent econometric studies have had this framework as the point of departure. It provides one way of linking econometric investigation about economic fluctuations to economic theory. One can therefore expect that the framework is superior to largely atheoretic frameworks such as the ones utilized, for example, in Blanchard (1993) or Sauramo (1996), because the interpretation of shocks should become easier.

However, the usefulness of that kind of investigation crucially depends on how well the framework fits the data. Finding a suitable framework for Finland is not easy. Until the mid eighties, the financial markets were regulated and therefore the standard textbook versions were more or less inapplicaple in the description of the behaviour of the economy. The deregulation of the financial markets has brought about a drastic change, but this does not necessarily make the analysis easier: institutional changes were accompanied by shifts in the exchange rate policy and monetary policy regimes, which complicates the use of the standard IS-LM framework or its cousin, the Mundell-Fleming framework.

The paper illustrated that, when the Finnish data is used, the identification of shocks which would be compatible with the conventional aggregate demand – aggregate supply framework was difficult. In particular, the identification of aggregate supply shocks turned out to be a very knotty task.

Within the traditional aggregate demand aggregate supply framework positive aggregate supply shocks (for example, technology shocks or labour supply shocks) are deflationary, i.e. they decrease prices. The shocks which were supposed to be (positive) aggregate supply shocks turned out to be inflationary, however. Thus the shocks did not satisfy this over-identifying restriction.

In the paper, as in numerous other papers, the classification of shocks into aggregate demand and aggregate supply shocks rests on the assumption about the vertical long-run supply (or Phillips) curve. If that is assumed to exist, aggregate demand shocks do not affect output in the long run. Positive aggregate demand shocks, which are inflationary, can have only a transitory influence on real output. In the long run they only increase prices. Consequently, aggregate demand and aggregate supply shocks can be identified by using a long-run (zero) restriction. The use of such a restriction was pioneered by Blanchard and Quah (1989).

The assumption about the vertical long-run Phillips curve is, of course, problematic. It is easy to think of channels through which aggregate demand shocks may have a long-lasting, or even permanent, effect on output (capital accumulation, hysteresis in the labour market, increasing returns to scale etc.) One of the main conclusions drawn in Sauramo (1998) was that the assumption about the vertical long-run Phllips curve may not be well-grounded in the case of Finland.

This conclusion is consistent with the view that, traditionally, economic growth has been demand-led in Finland with demand for exports being the main source of the growth. However, economic developments during the past ten years have been so peculiar in Finland that the results of Sauramo (1998) should not be interpreted as simply reflecting this traditional Finnish growth pattern.

Even though the framework based on the vertical long-run Phillips curve does not seem to work very well in the case of Finland, it does not mean that there does not exist an aggregate demand aggregate supply framework which would be useful in the description of economic fluctuations in Finland.

In Sauramo (1998) the main difficulty was the identification of aggregate supply shocks. The assumption about the vertical long-run Phillips curve did not produce shocks which could be interpreted as, for example, technology or labour supply shocks. In this paper I attempt to identify aggregate supply shocks (i.e. technology shocks) by utilizing identifying assumptions which do not necessarily imply the existence of a long-run vertical Phillips curve.

The basic idea is very simple: in using a structural VAR model I identify technology shocks by assuming that they are the only source of permanent changes in the level of labour productivity. Other shocks, whether they are aggregate demand or supply shocks, can have a permanent influence on the level of output. In this sense the assumption used in this paper is more general than the one used originally in Blanchard and Quah (1989). This paper draws mainly on Gali (1996) in which the main identifying restriction is rationalized by a new Keynesian dynamic general equlibrium model.

The main finding of this paper is that the identifying long-run restriction yields plausible technology shocks. They are plausible in the sense that positive technology shocks are deflationary and, as the theoretical model suggests, reduce demand for labour at least in the short run. However, they did not play a major role either in the boom or in the depression. The boom and the depression are explained by non-technology shocks. As in Sauramo (1998), the best way of characterizing these shocks is to regard them as aggregate demand shocks.

In the next chapter, I briefly discuss the framework and the data. Chapter 3 contains the main results and Chapter 4 concludes the work.

• ISSN: 1236-7184
• ISBN: 952-5071-25-1
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