Long-run identifying restrictions on VARs within the AS-AD framework

Bayoumi and Eichengreen’s (BE, 1994) article has been very influent in the empirics of the core-periphery view of fixed exchange rate agreements. They rely on the basic AS-AD macroeconomic model in order to identify supply and demand shocks through long-run restrictions in vector autoregressions. Doing this should enable one to assess the size of such disturbances and the asymmetry between countries. While reference is usually made to Blanchard and Quah (BQ, 1989), it is shown here how this factorization has been modified by BE and how the two resulting decomposition schemes can be linked. Contrary to BE’s premise, relaxing the assumption of shocks of equal size is not just a matter of scale. The empirical properties of the exchange regime are modified, especially as regards the correlation of shocks. Given the VAR setting used in the related studies, it is also established that zero-constraints on either instantaneous or long-run impulse responses provide identical results. An empirical assessment of the euro currency area over 1996-2008 illustrate these points. The recorded evidence suggests that non-zero restrictions imply slope coefficients of the AS and AD curves close to values derived from New-Keynesian models. b