American Economic Association

The Dynamic Effects of Aggregate Demand and Supply Disturbances: Reply

Author(s): Olivier Jean Blanchard and Danny Quah
Source: The American Economic Review, Vol. 83, No. 3 (Jun., 1993), pp. 653-658
Published by: American Economic Association
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The Dynamic Effects of Aggregate Demand and Supply

Disturbances: Reply
By OLIVIER JEAN BLANCHARD AND DANNY QUAH*

Marco Lippi and Lucrezia Reichlin

(1993), in their criticismof our work, have
uncovereda Pandora'sBox of difficultiesin
interpretingVAR's. In this reply we give
our evaluation of the significanceof these
difficulties;we outline what we take to be
the key contributionsand shortcomingsof
Lippi and Reichlin's note. At the end, we
will conclude that the points that Lippi and
Reichlin (hereafter LR) raise are relevant
for macroeconometricpractice in general,
beyond their application to our work. Finally, we provide yet a new reason for
macroeconometricians
to take heed of LR's
criticism;this reason lies in the nonfundamentalnessthat can be induced by the simple mechanicsof manipulatingcointegrated
systems.Such a link between nonfundamentalness and cointegration has not, to our
knowledge,been made explicitin the literature.

cannot. The implicationsof this distinction

are most easily understood by considering
the univariatecase; extension to multivariate models involvesno new ideas.
Take the simplestpossible example.Suppose that X is white noise, with disturbance E:
X(t)

= 8(t).

Notice that E itself might be a distributed

lag function of yet anotherwhite-noise disturbance:
-AL
11-A1L
6(t) =
A-AlL771(t)

for any A1with modulusgreaterthan 1, and

71l white noise. (To see this, just calculate

the covariogramof the right-handside, and

notice that it vanishes at all nonzero lags.)
Such a moving-averagerepresentation,

I. NonfundamentalRepresentation
LR construct nonfundamental represen-

tations from the VAR's that we estimated.

Such representationscan potentially alter
our conclusionson the relative importance
and the dynamicsof the different kinds of
disturbancesthat we identified. To clarify
this, it is useful to recall some time-series
facts-in a way different from that given
in LR.
Fundamentalrepresentationsare moving
averages in disturbanceswhere the disturbances can be recovered as (mean-square
limits of) one-sided convergent distributed
lags in observablevariables.Nonfundamental representations are those where they

EconomicsDepartment,MassachusettsInstituteof
Technology,Cambridge,MA 02139, and Economics
Department, London School of Economics, London
WC2A2AE, United Kingdom.
653

X(t)Xt=1-A1L-1 711(t)
1-A- L

j21

gives disturbances ql that are nonfundamentalfor observedX. When A1is positive,

then the dynamic response of X to m71
is
contemporaneouslypositive, after that negative, and subsequentlyit decays monotonically to zero. If, on the other hand, A1 is
negative, then the response is positive for
the first two periods, and after that it oscillates aroundzero, again decayingover time.
There might appear to be a distinctive
pattern in the moving-averagecoefficients
above: if the initial impact is positive, then
negativecoefficientsfollow;if the initial impact is negative, then positive coefficients
follow. A balancingof negativeand positive

654

THE AMERICAN ECONOMIC REVIEW

JUNE 1993

effects seems to occur so that the resulting

dynamicsremainthose of white noise.
Such a distinctive pattern is, however,
spurious;as the notation above suggests,we
can further take r1uto be a distributedlag
functionof yet anotherwhite noise,

process can have moving-averagerepresentationsthat mix fundamentaland nonfundamental parts.

Realizing this, we see that the LR criticism of our work is really independent of
structural VAR interpretationin specific,
and empiricalVAR analysisin general.It is
that VAR models, as typicallymaniputrue
1-A2L
lated, recover only disturbances that are
2-1 772(t)
IA21> 1
771l(t) =
1-A2 L
fundamental;but so does almosteveryother
model used in analyzing time-series data.
and even allow the A coefficients to be
The problem that LR raise remains perticomplexby takingthem in a conjugatepair: nent in even the most straightforwardBoxJenkinstime-seriesanalysis.2
1-A2L
1-A2L
Sayingthis, of course, does not absolveus
n() 1 A2-1L 1--2-'L
3t
IA1>.
and other VAR users from the responsibility of dealing with this difficulty.Some will
What do we learn from this? We realize just assume away the supposed subtlety(as
that certain nonfundamentalmoving-aver- we did in the first line of page 657 of our
original article). That assumingaway, howage patterns turn out to be impossible for
particularprocesses-for instance, a white- ever, becomes more incredible,and the supnoise sequence cannot, except in its funda- posed subtlety becomes less subtle, as exmental representation,have all nonnegative amples accumulate showing the economic
coefficientsin its movingaverage.But, tak- relevance of nonfundamental representaing different convolutions of the factors tions. In addition to LR, the published
above also establishesthat almost any other record shows such examples in the studies
pattern in the moving-averagecoefficients of Carl Futia (1981), Robert Townsend
-hump-shaped or otherwise-is achiev- (1983), Quah (1990), and Hansen and Sargent (1991), among others. These studies
able, subjectonly to the constraintthat the
have presented economic models where
zeros of the numeratormovingaverageare
inside the unit circle.' The resulting nonfundamentalnessis likely to arise:a unifying thread running through these papers
moving-averagerepresentation,
is the feature that economic agents observe
information that the econometriciandoes
J 1-A L
not.
X(t)= 1I 1 -A -L 77i(t)=Cj(L)- (t)
j
In those models, nonfundamentalness
turns out to be the natural, and necessary,
always gives white noise, provided that consequenceof economicreasoning.A sim> 1. When, to begin, X is not white ple example is useful here to make the
IA41
point concrete.3 In the Friedman-Muth
noise, the possibilitiesbecome richer,and a
model of permanentincome and consumption, permanentand transitorydisturbances
1It is useful here to note the differencebetween
perturbincome:
fundamentaland invertiblemoving-average
representations. Invertibilityrules out, in addition,movingaverages whose coefficientssum to zero (i.e., have a "unit
root" in the movingaverage).Because such processes
can be arbitrarily
well approximatedin mean squareby
processeswith no such unit roots, those disturbances
remain fundamentalfor the observed process. Thus,
for example, while X(t) = (1 - L)E(t) is noninvertible,

the disturbance? remains fundamentalfor X. This

makes clear that the nonfundamentalnessunder discussionhere is not simplya matterof overdifferencing.

Y(t) = Y1(t) + YO(t)

As LR emphasize, some of the points that they

raise are also made (in a purely theoretical setting) by
Lars Peter Hansen and Thomas Sargent (1991).
3This example is modified from Quah (1990 pp.
471-2).

VOL. 83 NO. 3

BLANCHARD AND QUAH: DYNAMIC EFFECTS, REPLY

655

with +(p) =1 + (1 - 32). The first row of

this certainly gives permanent and transiAY1(t) = El(t)
tory components in Y, associated with v1
and vo, respectively. Note, however, that
= EO(t).
YO(t)
here the identified permanent distur(The disturbancesEl and Eo are uncorre- bance v1 has first a positive impact on inlated white noises.) If consumption obeys come Y, (3- /3)/4(,B3),and then a reduced
p)2]/O(p).
By coneffect, [(3- 8)-(1the permanent-incomehypothesis,as for exthe
true
Friedman-Muth
permanent
trast,
ample in Robert Hall (1978), then
disturbanceEl has only a one-time permanent effect.
AC(t) = El(t) + (1 -13)Eo(t)
To summarizethis section, the firstlesson
where E (between0 and 1) is the consumer's is that nonfundamental representations
subjectivediscount factor. Puttingthese toneed have no distinctiveshape:from this we
gether we have
conclude that such representationscannot,
on a priori grounds,be excludedfrom consideration.The opposite question-whether
IAY(t)1 [1 1- L[El(t)
there is reason for considering nonfunda1[ 1 -3 [8O(t)]
AC(t)
mental representationsin the first place-is
answeredpositively,for different economic
The determinant of the moving-average models, by the referencesabove.The example we give also shows explicitlythat nonfunction is (1- ,3) -(1 - z) = z - E and thus
fundamentalnesscan arise in a completely
vanishes at z = 3, inside the unit circle.
innocent,uncontrivedway.
This moving-average representation for
We now turn to LR's own argumentfor
(AY,AC)-the naturalconsequence of the
allowingnonfundamentalrepresentations.
permanent-incomehypothesis-is thus nonfundamental.
II. The Lippi-ReichlinCriticism
As suggested by the LR reasoning, the
permanentand transitorycomponentsin Y
In our view, criticism along the lines of
are then not recoverablefrom the joint history of Y and C. From the movingaverage LR's will significantlyaffect macroeconometric practice if the underlyingideas satof (AY,AC)' we see that the vector (Y,C)'
isfy at least one of the followingcriteria:
is not cointegrated.A VAR for (AY,AC)' is
thus well specified;if one calculatessuch a
(i) alternative nonfundamentalrepresenVAR and then uses the identification
tations display properties that are
scheme suggestedin our originalpaper, one
economically sensible, yet markedly
recoversuniquely:4
different from those in fundamental
representations;
rAY(t) 1
[AC(t) j
(ii) an interesting economic hypothesis
producesthe nonfundamentalness;
(iii)
practitionersface pervasiverisk of in1
4(1) -1 [3-f3-(1-_)2L
[p-(1-p)2](1-L)
advertentlyinducing nonfundamentalJ
-(1-10)4()
4(p1)
ness in their interpretationof data.
with

C/
vo(t)1

4The unique representation given here arises from

the informational restriction used in our original paper
or, equivalently, the fundamentalness that LR are criticizing.

Before we discuss it more fully below, notice here that (iii) differsfrom a researcher's
simplynot takingnonfundamentalnessto be
a relevant possibility;we mean to emphasize in (iii) that nonfundamentalnessmight
actuallybe created in the process of manipulating a time-seriesmodel.

656

THE AMERICAN ECONOMIC REVIEW

From the perspectiveof (i) we are struck

by the similarityof LR's reported impulse
responses,both acrosstheir differentexperiments and compared to the impulse responses in our originalpaper. It is true that
the variance decompositions (equivalently,
the impulseresponses)change at shorthorizons, but the general pattern of impulse
responses is quite close to what we obtained. We conclude that the resultingdynamic variance decompositions,while differingin details at particularhorizons,must
be surprisinglysimilarto ours.
This emphasizesthe importanceof theoretical propositionssuch as that which LR
present, following their equation (14), in
delineatingjust how differentthe empirical
results could have turned out to be. That
result shows that a researcher can always
produce a nonfundamentalrepresentation
which allocatesto the hypothesizeddemand
disturbanceany relative importancefrom 0
to 1. That LR did not present such an
example is (we conjecture)due to the unreasonable interpretationsthat would have
to be given to it in the current demandsupplywork.
By contrast, from the perspective of (ii)
we find LR's reasoningto be unsatisfactory.
Admittedlythey intend the analysisin their
section III to be no more than suggestive.
Certain points in that section, however,do
bear emphasis.Notice that the only reason
nonfundamentalnessarises in their model is
through the moving-averagerepresentation
for AO.LR assume this representationto be
nonfundamental. Why? Would any researcher-counterfactually,havingobservations on and interested in fitting a timeseries model for AO-have assumed this?
We think not; but then why bring in that
complicationwhen, to begin, AG is unobservable?
We are also unconvincedthat the learning-by-doing or knowledge-accumulation
process(the S-shapeddiffusioncurvein LR)
necessitatesa nonfundamentalmovingaverage. Instead, we see that their normalized
S-shaped diffusion curve, in another guise,
is simplya cumulativedistributionfunction;
and for that, all that is needed is a movingaverage representation whose coefficients

JUNE 1993

are nonnegative: plenty of fundamental

movingaverageswill do that nicely.There is
no way to tell, apartfrom explicitlycalculating the zeros, when a moving averagehaving all nonnegative coefficients is fundamental and when it is nonfundamental.This
inabilityto say anythingconcrete by purely
analyticalmethods should not be confused
with a necessity that the representationbe
nonfundamental.
Despite the criticismswe have made here,
we acknowledgethat we accede the point to
LR. We, as have many others, simply ignored an importantadditionaldimensionin
the identifyingof VAR models. The entire
point of structuralVAR analysisis exactly
identificationof alternativedisturbances:all
possibilitiesneed to be considered.
III. CointegratedModels

In this section, we now propose to add a

new reasonto the list of how nonfundamental representationscould arise:this takes us
back to our point (iii) above. It turns out
that the Beveridge-Nelson decomposition
(Stephen Beveridge and Charles Nelson,
1981) potentially induces nonfundamentalness. This fact does not seem to be widely
recognized;it will be embedded in our example below. More importantly,however,
recall that Beveridge-Nelson-likecalculations are used to derive common-trends
representationsin cointegratedtime series
(e.g., Robert Engle and Clive Granger,
1987). Thus it would seem that nonfundamentalness is a property that is especially
relevantin cointegratedmodels. Again, this
possibilityhas not been raised in the literature.
To make our assertionprecise, let X be a
vector of integrated series; let its first differenceshave the fundamentalmoving-average representation:
AX(t) = C(L)r(t)
detC(z) =*Ofor all lzI < 1
E

seriallyuncorrelated.

As in our original article, a researcher is

VOL. 83 NO. 3

BLANCHARD AND QUAH: DYNAMIC EFFECTS, REPLY

interestedin the dynamiceffects of E on X;

again, some theoretical reasoning might
suggest those to be of economic significance. Do standardproceduresused in the
analysis of cointegrated systems correctly

so that
detC(z) = (1-A1z)(1-A2z)(1-pz)

recover E, and thence those dynamic ef-

fects? We show below that for commontrends representationsthis is, in general,

not guaranteed,thus extendingthe scope of
LR's criticismin a new and fertile direction.
FollowingEngle and Granger(1987), we
apply Beveridge-Nelsoncalculationsto get
the followingrepresentation:
(1)

X(t) = X(O)+C(1) E ej)

-(1-AJ)l-

A2)(1-

p).

The functiondet C clearlyvanishesat z = 1,

and thus X above is cointegrated.Further,
for p close to 1, det C alwayshas its remaining zeros close to A- 1 and AH-1,and thus
strictlyoutside the unit circle. For instance,
if p is 0.95, A1is 0.6, and A2 is -0.7, then
the two zeros of det C, other than at unity,
are at - 1.417 and 1.708.

j=l

t>1

+C*(L)E(t)

657

In the present example, the corresponding common-trendsrepresentation(1) has

short-rundynamicsgiven by

where the coefficientsin C* are given by

Cj* = -

j > 0.

E Ck

C*(Z)

=[[(Al

+ A2)-AlA2-AlA2Z

k>j

This equation decomposes X into so-called

long-run and short-run dynamics; many
cointegration representations derive from
exactlysuch a decomposition.
In cointegration analysis most attention
has focused on the propertiesof the matrix
C(1). The dynamicsin the stationaryresidual C*(L), are captured, in practice, by
includingsufficientlags of AX in the empirical analysis. From the perspective of the
issues discussed above, such a procedure
would be unobjectionableif C* were to be
invertible.
It is easy to show that when X is I(1)-or,
more correctly,when dC(z)/dz is full-rank
at z = 1-then C*(1) is full-rank. Thus,
det C* has no zeros at z = 1. That fact

alone, however, does not imply that C* is

invertible;for that, C*(z) must be full-rank
everywhere on Iz ?< 1.
A simple examplesufficesto show that no
reasonable regularityconditions will guarantee this last property. Suppose that for
JA11,JA21,and lp1 less than 1, with p different from zero, we have:
C(Z)=

[(1

AZ)(1

A2Z)

(1-A1)(1

A2)(1-P)

so that
detC*(z) = p([(A1 + A2) - A1A2]- A1A2z).
This determinantalfunction has only one
zero, at [(A1+ A2)- A1A2]/AlA2:there is no
guaranteethat this zero lies outside the unit
circle. In fact, for the numerical example
we gave above, this zero is at - 16/21,
well inside the unit circle. We concludethat
C* correspondsto a nonfundamentalrepresentation. In other words, for this model
the common-trends representation has
short-rundynamicsC* whose disturbances
differ substantivelyfrom the original ones:
those disturbances of interest are never
recoverableby any orthogonalizationof the
short-runcomponents' innovationsfrom a
common-trendsmodel.
In this section we began with a model for
which the disturbancesof interest are fundamental. We have shown that one standard representation for cointegrated syscommon-trends one-yields
tems-the
short-run dynamics that are intrinsically
different from those of the original disturbances. Thus analyzingthat representation

658

THE AMERICAN ECONOMIC REVIEW

does not obtain the disturbancesor the dynamics of interest. By contrast,LR suggest
that nonfundamentaldisturbancesmight be
of interest. If so, standardmethods-such
as in our original article-are deficient,
since those can only recover fundamental
disturbances.
It is useful to remarkhere that the wealth
of literature on cointegrationhas focused
on statistical inference, rather than on the
issue of identificationof disturbances.For
inference, it is immaterialwhether or not a
particular representation is fundamental.
For identification,it is very material,as LR
show.
IV. Conclusion

To summarize,we agree with the main

thrust of LR's criticism, although we are
critical of details in their implementation.
The identificationproblem that they raise
-the existence of nonfundamentalrepresentations-is an issue whenever a researcherwishes to give an economic interpretationto time series.
We have argued that nonfundamental
representationsare not absolutelynecessary
to capturemanydynamiceffects of interest.
At the same time, neither can those representations be dismissed always and everywhere. Sometimes,they turn out to be precisely the phenomenaof interest.
That constitutes the first part of our reply. For Section III, it is useful to relate
whatwe have done here with the literature's
progression,followingLR. Our originalarticle began by assuming a fundamental
moving-averagerepresentationin aggregate
demandand supplydisturbances;our paper
then showed how to recover those disturbances using a VAR. LR's note begins by
assuminga nonfundamentalrepresentation
and then criticizes our empiricalwork because our VAR, as we manipulatedit, could
not recover the nonfundamental disturbances. Up to this point, however,the question is a matterof choice in assumptions.By
contrast,the discussionof Section III shows
how a nonfundamentalrepresentationcan
naturallyarise in cointegratedsystems.Such
systemsare now routinelyused in empirical

JUNE 1993

work in macroeconomics.We have shown

here that the force of LR's criticismapplies,
even more strongly, to such systems [see
point (iii) of our Section II]. Unlike users of
standardVAR's (such as in our application
to demand and supply disturbances),users
of common-trendsmodels need to prove
that the disturbancesthey uncover are the
ones originallyof interest:they do not have
the freedom simply to make that assumption, as we did.
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New Approach to Decomposition of Economic Time Series into Permanent and
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Engle, Robert F. and Granger, Clive W. J.,
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251-76.
Futia, Carl, "Rational Expectations in Stationary Linear Models," Econometrica,
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