Temporary cycles or volatile trends? Economic fluctuations in 21 OECD economies

Whether it is feasible to use various types of economic policy measures to reduce fluctuations in economic activity will depend on the source of the fluctuations. In particular, policy should respond in different ways to transitory disturbances to aggregate demand and more permanent shifts in aggregate supply. The paper uses small structural var autoregressions to distinguish between these two types of disturbances. The models utilise price and output data in each of 21 OECD economies. The results indicate the supply and demand disturbances are of roughly equal importance in explaining fluctuations in growth and inflation across this wide range of economies. This supports the view that economic fluctuations cannot be characterised as a cyclical changes around a fixed trend (the Keynesian synthesis) or as continual movements in underlying supply potential (a view of real business cycle theorists). Rather, they are an amalgam of both effects. Amongst the G7 economies, demand shocks have the greatest effect on output in the UK and US, and weakest in Japan and Germany. These results support the general view of activeness of government policy in these countries and provide little evidence of successful stabilisation. A method of distinguishing the effects of output and inflation on each type of disturbance is then outlined. This makes it possible to measure 'supply potential' for each economy; there is evidence of a steady decline in the rate of increase in supply potential over time, a view consistent with the 'catch up' theory of post-war economic growth.