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Policy Discussion Paper, No. PDP 2007-2, April 2007
Fundamental Economic Shocks and the Macroeconomy

This paper asks how macroeconomic and financial variables respond to economic impulses. The author identifies structural economic shocks using a strategy that utilizes measures of economic shocks explicitly derived from economic models. He uses this approach to identify technology shocks, marginal-rate-of substitution (labor supply) shocks and monetary policy shocks in the context of a Factor Augmented VAR similar to that developed by Bernanke, Boivin and Eliasz (2005). He then examines the Bayesian posterior distribution for the responses of a large number of endogenous macroeconomic and financial variables to these three shocks. These shocks account for the preponderance of output, productivity and price fluctuations. He finds that technology shocks have a permanent impact on measures of economic activity, even though this characteristic of technology shocks is not imposed as an identifying restriction. In contrast, the other shocks have a more transitory impact. Labor inputs have little initial response to technology shocks; the response builds steadily over the five year period. Consumption has a sluggish response to the technology shock, consistent with a model of habit formation. Monetary policy has a small response to technology shocks, but “leans against the wind” in response to the more cyclical labor supply shock. This shock has the biggest impact on interest rates. Stock prices respond to all three shocks. A number of other empirical implications of our approach are discussed.

Policy discussion papers are not edited, and all opinions and errors are the responsibility of the author(s). The views expressed do not necessarily reflect the views of the Federal Reserve Bank of Chicago or the Federal Reserve System.

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