Interpreting Permanent Shocks to Output When Aggregate Demand May Not be Neutral in the Long Run

This paper studies Blanchard and Quah’s (1989) statistical model of permanent and transitory shocks to output using a set of arguably more plausible structural assumptions. Economists typically motivate this statistical model by assuming aggregate demand shocks have no long-run effect on the level of output. Many economic theories are, however, inconsistent with that assumption. We reinterpret this statistical model assuming a positive shock to aggregate supply lowers the price level and in the long run raises output while a positive shock to aggregate demand raises the price level. No assumption is made about the long-run output effect of aggregate demand. Based on these assumptions, we show that a puzzling finding from the empirical literature implies that a positive (negative) aggregate demand shock had a long-run positive (negative) effect on the level of output in a number of pre-World War I economies.