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10% and the latter for about 15% of the medium-term forecast variance in output. The price andwage mark-up shocks do not seem to matter for output variability.That both “supply shocks”, the productivity and labour shock, account for only 40 percent of thevariance of output in the long run seems to run counter to the results from identified VAR studiesthat those shocks account for most of the long-run variance (e.g. Shapiro and Watson, 1989 andBlanchard and Quah, 1989). However, it should be noted that in those studies it is assumed thatonly supply shocks affect output in the long run. The limited importance of productivity shocksconfirms the conjecture made in Gali (2000) that the negative correlation between output andemployment in response to a productivity shock raises serious doubts about the quantitativesignificance of productivity shocks as a source of aggregate fluctuations in industrialised countries.One factor which may explain the important role of the labour supply and monetary policy shocksin driving output, is that both those shocks can explain the significant positive correlation betweenoutput, consumption, investment and employment in the data. As will become clear in thediscussion of the historical decomposition, the relatively large contribution of monetary policyshocks to the variance in output, is mainly due to the disinflation period of the early 1980s and theERM crisis of 1992-93.Turning to the determinants of inflation, we find that at all horizons variations in inflation aremainly driven by price mark-up shocks. Empirically inflation is a quite volatile process. At the sametime inflation is estimated to respond only very sluggishly to current and expected changes in themarginal cost. It is therefore not very surprising that one needs quantitatively important “cost push”shocks to account for the short-run behaviour of volatile prices. Of course, these shocks couldcapture a whole range of shocks that are not accounted for in the stylised model such as changes inoil prices, terms-of-trade shocks, changes in taxes, etc. In the medium to long run, monetary policyshocks also account for about 20 to 40% of the inflation variance.Somewhat surprisingly, other shocks together typically account for less than 15% of the variance ininflation. One of the main reasons why technology and preference shocks do not affect inflationvery significantly, is that under the estimated monetary policy reaction function, interest ratesrespond quite strongly to those shocks, thereby helping to close the output gap and to avoidinflationary or deflationary pressures that may otherwise arise. Indeed, Table 3 shows that thenominal interest rate is mainly determined by the preference shock, the labour supply shock and theproductivity shock. This highlights the fact that the relative importance of the various shocks assources of business cycle fluctuations in output and inflation will very much depend on themonetary policy regime. In contrast, monetary policy shocks only account for maximum 10% of theforecast variance in nominal interest rates. Finally, as indicated before the inflation objective shockplays no role.26 NBB WORKING PAPER No.35 - October 2002
4.3 Historical decompositionGraphs 13 and 14 summarise the historical contribution of the various structural shocks to outputand inflation developments in the euro area. This decomposition is based on our best estimates ofthe various shocks. While obviously such a decomposition must be treated with caution, it helps inunderstanding how the estimated model interprets specific movements in the observed data andtherefore can shed some light on its plausibility. 40Focusing on the decomposition of inflation first, it is clear that in line with the results from thevariance decomposition the short-run variability in inflation is mostly accounted for by “cost-push”shocks. In contrast, the secular part in inflation is mostly driven by monetary policy shocks.According to our model, monetary policy was the predominant factor behind the surge in inflationin the 1970s and its stabilisation from the late 1970s onward. Finally, the run-up in inflation in thelate 1980s and early 1990s is attributed to the various “supply” and “demand” shocks.The relative role of the various shocks during the 1970s is also clear from the decomposition ofoutput. While loose monetary policy contributed to offsetting the fall in output due to negativesupply and demand shocks in the 1970s, it contributed very little to output variations in the 1980sand 1990s. Most of the variation in output since the mid 1980s seems to be due to the varioussupply and demand shocks, although the monetary policy tightening during the ERM crisis of 1992has contributed somewhat to the 1993 recession.5 Output and interest rate gaps: an applicationIn a simple benchmark New-Keynesian model with only nominal price rigidities and no “mark-up”shocks, Woodford (2002) has pointed out that optimal monetary policy will be able to replicate theflexible price equilibrium, thereby restoring the first best. In such a model, the output gap or the realinterest rate gap, both defined as deviations from their flexible price level, are useful indicators foroptimal monetary policy. 41 Our analysis differs from Woodford’s analysis in two important ways.First, due to the presence of both nominal price and wage rigidities, it will no longer be possible formonetary policy makers to restore the flexible-price equilibrium in our model. However, Erceg,Henderson and Levin (2000) have shown that in this case targeting a weighted average of priceinflation and the output gap, defined as the deviation of actual output from its flexible price level,comes close to optimal monetary policy. Second, in Erceg, Henderson and Levin (2000) andWoodford (2002), all shocks are coming from technologies and preferences. As a result, in theabsence of other steady-state distortions, the flexible-price output and real interest rate level is alsothe efficient level and can thus be seen as the appropriate target level. In our model, we have4041It needs to be mentioned that while the sample in Graphs 13 and 14 starts in the early 1970s, the first nine years of thesample are used for the initialisation of the Kalman filter and are not used to estimate the structural parameters. Giventhe large monetary policy shocks, doing so would probably have implications for the stability of the policy rule.See also the discussion in Neiss and Nelson (2001) and Gali (2000).NBB WORKING PAPER No. 35 - October 2002 27
Page 3 and 4: AbstractThis paper develops and est
Page 5 and 6: TABLE OF CONTENTS:1. INTRODUCTION..
Page 7 and 8: 1. IntroductionIn this paper we pre
Page 9 and 10: shock leads to a gradual increase i
Page 12 and 13: 2.1.2 Labour supply decisions and t
Page 14 and 15: The first-order conditions result i
Page 16 and 17: jt⎛⎜ p− MCtt )⎜⎝Ptp,t(24)
Page 18 and 19: where β = 1/(1−τ+ r k ) . The c
Page 20: price and wages in the absence of t
Page 23 and 24: whereÊ t denotes the number of peo
Page 25 and 26: curve for a normal distribution wit
Page 27 and 28: where p(θ A ) is the prior density
Page 29 and 30: 3.3.2 Comparison of empirical and m
Page 31: the effects on marginal cost and in
Page 35 and 36: very much in response to the variou
Page 37 and 38: estimate of potential output should
Page 39 and 40: Table 1: Parameter estimatesPrior d
Page 41 and 42: Table 3: Variance decompositionC I
Page 43 and 44: 300020001000persistence productivit
Page 46 and 47: Graph 3: Productivity shock (1)0.50
Page 48 and 49: Graph 5: Wage mark-up shock0.050yc0
Page 50 and 51: Graph 7: Preference shock1.210.8yc0
Page 52 and 53: Graph 9: Equity premium shock0.30.2
Page 54 and 55: Graph 11: Monetary policy shock0-0.
Page 56 and 57: Graph 13: Inflation decomposition -
Page 58 and 59: Graph 16: Labour supply shock: flex
Page 60 and 61: Graph 18: Investment shock: flexibl
Page 62 and 63: Graph 20: Natural Output Gap105Natu
Page 64 and 65: ReferencesAbel A.D. (1990), “Asse
Page 66 and 67: Geweke J. (1999), “Computational
Page 68 and 69: NATIONAL BANK OF BELGIUM - WORKING
Page 70 and 71: 24. "The impact of uncertainty on i

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