Interaction between supply and demand in production and employment

A major aim of recent empirical modelling of the business cycle is to identify the relative importance of aggregate supply and demand shocks. Supply or technology shocks are associated with permanent (structural) effects on economic activity whereas demand shocks are related to temporary (cyclical) effects. Most studies in this vein use multivariate VAR ­models or the common trends-cointegration approach in order to disentangle supply and demand shocks. As an alternative, this paper uses the methodology of unobserved (or structural) components time series models as set out in Harvey (1989) for identification of technology and demand shocks in a two equation system of labour productivity and industrial output. The novelty is the introduction of correlation between the two types of shocks such that the mutual dependency of these shocks can be estimated explicitly. This is because technology shocks will have cyclical (temporary) effects, and demand shocks will have structural (permanent) effects, which are not fully described by the interaction of the endogenous variables in the model. The estimation procedure is set out in Koopman et al. (1995). The data is quarterly time series of labour productivity and industrial output for France, Germany, the Netherlands, the United Kingdom and the United States. Our results show that the covariance of the dynamics of supply and demand shocks appears to be important in these countries. It indicates a good coordination is needed between structural and cyclical policies.