Historical Decomposition of Aggregate Demand and Supply Shocks in a Small Macro Model

We estimate and analyze the impact of multiple aggregate demand and aggregate supply shocks in a small macroeconomic model of the economy. The analysis serves two purposes. First, we assess the relative importance of the various shocks in explaining the path of output over the past three decades. Second, we conduct counterfactual policy experiments which show the effects of alternative policies on key macro variables. We find that using the monetary policy tool (reserves or the base) such that constant money growth occurs would have produced superior economic results. Fluctuations in macroeconomic activity are generally explained in terms of shocks to aggregate demand and supply. Many theoretical models suggest a role for both types of shocks. Demand shocks, including but not limited to policy innovations, are typically thought to have real effects in the short-to-medium run but not in the long run. Supply shocks, including resource and technology shocks, have effects in both the short and long runs. Most empirical studies find important effects of both aggregate demand and supply shocks.' Although demand and supply shocks are important conceptually, in applied work the nature of the identified shocks has differed. Some studies identify only one generic shock to aggregate