Walter Enders & Stan Hurn
Abstract
The standard Blanchard-Quah (BQ) decomposition forces aggregate demand and supply shocks to be orthogonal. However, for a variety of reasons, this assumption may be problematic. For example, policy actions may cause positive correlation between demand and supply shocks. This paper employs a modification of the BQ procedure that allows for correlated shifts in aggregate supply and demand. The method is demonstrated using Australian data. It is found that shocks to Australian aggregate demand and supply are highly correlated. The estimated shifts in the aggregate demand and supply curves are then used to measure the effects of inflation targeting on the Australian inflation rate and level of GDP.