Empirical Estimates of the Short-Run Aggregate Supply and Demand Curves for the Post-War U. S. Economy

Abstract

This paper presents estimates of the short-run aggregate supply and demand curves for the post-war U.S. economy using a structural vector autoregression (SVAR). Following the work of Blanchard and Quah [4] (henceforth BQ) I assume that aggregate demand shocks have no long-run impact on the log of real output. In contrast to BQ I use aggregate output and prices while they use aggregate output and the unemployment rate. By replacing unemployment with prices I can estimate the slopes of the aggregate supply and demand curves for the U.S. economy. My purpose in extending the work of BQ in this direction is threefold. First, to investigate whether the decomposition method proposed by BQ yields textbook aggregate demand and supply curves; second, to investigate whether the supply and demand shocks derived from this method correspond to historical demand and supply shocks; and third, to test the stability of the slope of the aggregate supply curve. The once-well-accepted stylized characterization of prices as procyclical has recently been questioned (Kydland and Prescott [13] and Wolf [23]). Procyclical prices were previously thought to be evidence that the cycle was aggregate demand driven. The studies by Kydland and Prescott and Wolf show that prices are either acyclical or countercyclical thus indicating that aggregate supply shocks may play a role in business cycle fluctuations. In this paper I test whether, once output movements and prices are decomposed into demand and supply driven components, the aggregate demand induced movements in prices are procyclical and the aggregate supply induced movements in prices are countercyclical. I find that the aggregate supply curve does slope upward and the aggregate demand curve does slope downward. Thus, the evidence presented here is consistent with the notion that the lack of a consistent cyclical pattern in the price level is due to the fact that both demand and supply shocks generate business cycle fluctuations. Secondly, I extend BQ by investigating whether the movements in output and prices due to aggregate demand and supply shocks correspond to specific episodes of demand and supply shocks during the post-war era as defined by independent sources. For example, does this estimation technique attribute movements in output due to oil price shocks to aggregate supply and