On the permanent effect of an aggregate demand shock: Evidence from the G-7 countries

This paper extends the work of Cover, Enders and Hueng (2006) to examine the idea that an aggregate demand shock may have permanent effect on the output level by indirectly shifting the aggregate supply curve. We utilize the bivariate SVAR modeling and adopt an identification scheme, which allows for the possibility that a shift in the aggregate demand curve may induce the long-run aggregate supply curve to shift. We have shown that aggregate supply shocks are positively affected by the demand shocks in each of the G-7 countries. It is found that a one-time positive aggregate demand shock increases the output level permanently in these industrialized economies. We have also shown that our decomposition strategy can help resolve anomalies in the responses of inflation to a positive aggregate supply shock observed in a simple Blanchard-Quah decomposition.

Research Highlights► This study shows that an aggregate demand shock may affect the aggregate output level permanently by indirectly influencing the supply side. ► The aggregate demand and supply shocks are found to be positively correlated in each of the G-7 countries. ► This study also shows that the traditional approach to identifying macroeconomic shocks may lead to anomalies in the response of inflation if we don't allow the correlation between aggregate demand and supply shocks. ► This paper has shown that the identified aggregate demand shocks are positively correlated with productivity in each of the G-7 countries. This finding points to the fact that a demand shock may influence the overall productivity of an economy, which induces the aggregate supply curve to shift and causes permanent effect on the output level. ► The finding of this paper, especially in the wake of recent global recession, has important policy implications. The findings of the paper suggest that a recession may cause an economy to reach the higher level of unemployment and lower level of output permanently if no policy action is taken. ► An expansionary demand management policy (to combat recession) may not be as harmful for inflation as it was previously thought, as this paper suggests that supply shocks are the main contributors for the variation in inflation in most of the G-7 countries.