## 1. U.S. Adjustment AS/AD

## Source details

**Canonical URL:** [1. U.S. Adjustment AS/AD](https://www.imf.org/-/media/files/publications/wp/2017/wp1755.pdf)

## Other formats

- [Markdown version](/-/media/files/publications/wp/2017/wp1755.pdf.md)
- [Structured JSON version](/-/media/files/publications/wp/2017/wp1755.pdf.json)

---

### I. Introduction — context, approach, and headline findings
- Historical context and motivation:
  - 1990s consensus: neither Europe nor the United States was an optimum currency area.
  - Bayoumi and Eichengreen (1993) documented larger dispersion of shocks in Europe than the United States.
- Approach and scope:
  - Distinguish temporary and permanent disturbances to output (interpreted as aggregate demand and supply shocks) using Blanchard-Quah decomposition.
  - VARs estimated with two lags.
  - Estimation period is 1990-2014.
- Key findings and surprising results:
  - The United States continues to resemble an optimum currency area more closely than the Euro Area under the symmetry-of-disturbances criterion.
  - Euro Area core–periphery distinction persists; post-euro core (highly correlated with Germany) includes Portugal, Ireland, Italy, Spain, and Greece (the GIIPS).
  - Price responses differ across jurisdictions:
    - United States: temporary positive shocks to output raise prices permanently; permanent positive shocks reduce prices.
    - Euro Area: permanent positive shocks to output raise prices rather than lower them (contrary to textbook AS/AD model).
- Interpretation: financial-hysteresis mechanism links supply and demand shocks via financial markets (financial accelerator):
  - Positive supply shocks → higher asset prices → increased bank capital and lending → higher investment and demand → further output increases and higher prices.
  - Negative demand shocks → lower asset prices → reduced lending → amplified declines in demand and output, leading to deflation.
- Institutional/regulatory drivers:
  - Euro Area banks: greater reliance on banks’ internal models and Basel risk weights; intensified bank competition and elimination of exchange risk after the euro increased elasticity of bank lending.
  - U.S. banks: constrained by a U.S.-specific “simple leverage ratio” (required commercial banks to hold at least 5 cents of capital for every dollar of assets), limiting the financial accelerator.
- Policy implication highlighted:
  - Need for vigorous, coordinated regulation of banking and financial systems by a single supervisor; monetary union without banking union will not work.

### II. Estimation results — data, methods, and impulse responses
- Data and methodology:
  - Variables: growth and inflation are first differences of the logarithm of real GDP and the GDP deflator.
  - Blanchard-Quah decomposition used to separate permanent (aggregate supply) and temporary (aggregate demand) shocks.
  - Countries/regions: eleven initial Euro area members and Euro area as a whole; eight U.S. BEA regions; ten additional advanced countries.
  - Sample choices: estimation period is 1990-2014; main correlations start calculations from 1994; exclude 2009 from correlation analysis.
- U.S. impulse-response results (textbook AS/AD):
  - Aggregate supply shock: gradual rise in output and fall in prices (downward-sloping AS in price-output space).
  - Aggregate demand shock: initial rise in output and prices followed by reversion of output with continuing higher prices.
  - Regional patterns: mineral-rich Southwest and Rocky Mountain regions have relatively flat aggregate supply curves.
- Euro Area impulse-response results (nonstandard for majority of members):
  - One shock raises output and lowers prices but is the temporary (aggregate demand) shock.
  - The other (permanent) shock raises output and produces little initial price change followed by gradual price increases.
  - Seven of 11 long-term EA members, including Germany, display the unconventional pattern; France, Belgium, Austria, and Finland conform to the traditional pattern.
  - Ten other advanced economies mostly conform to the traditional pattern; Japan resembles EA unconventional dynamics.
- Financial-hysteresis mechanism formalized:
  - Anticipated positive supply shock shifts AS rightward; higher asset prices and financial accelerator shift AD rightward.
  - Financial accelerator operates through bank capital effects and lenders’ internal models.
  - Reverse dynamics explain deepened declines and deflation when financial disruption occurs.
- Experiments controlling for financial conditions:
  - Added contemporaneous and first lag of change in real credit, real equity prices, and real house prices as exogenous variables in the VAR to approximate removing the financial accelerator.
  - Results:
    - For a typical country the long-term impact on output of an “aggregate supply” shock is twice as large when financial channel operates.
    - For the GIIPS the effect is thrice as large when the financial channel operates.
    - Removing the financial accelerator causes the high correlation of “aggregate supply” shocks between the GIIPS and Germany to fall dramatically while correlations for other EU countries are essentially unchanged.

### III. Correlation results — anchors, regional structures, and coherence
- Anchor regions:
  - U.S. anchor: the Mideast (mid-Eastern Seaboard).
  - Euro Area anchor: Germany.
- Sample adjustments for correlation analysis:
  - Start calculations using shocks from 1994 rather than 1990.
  - Exclude 2009 because it is characterized by an exceptionally large and highly correlated global shock.
- U.S. correlation structure:
  - Inner core (highly correlated with Mideast): New England, Great Lakes, Southeast, and Far West.
  - Periphery: Rocky Mountains, Southwest, and Plains.
  - Changes since earlier work: Southeast joined inner core; Plains moved to periphery.
- Euro Area correlation structure:
  - Lower correlations and less well-defined subgroups than U.S.
  - Periphery (high correlation with Germany, counterintuitively) comprises the GIIPS (Italy, Portugal, Spain, Ireland, Greece); Greece shows relatively high correlation of “aggregate demand” shocks.
  - Netherlands and Austria exhibit high correlations of “aggregate supply” shocks with Germany; France, Belgium, and Finland are in the outer circle (low correlations).
- Principal component coherence over time (proportion of variance explained by first principal component — exact values preserved):
  - Aggregate Demand:
    - EMU 1990-2001: 0.31
    - EMU 2002-2014 less 09: 0.29
    - Difference: -0.02
    - US regions 1990-2001: 0.75
    - US regions 2002-2014 less 09: 0.60
    - Difference: -0.15
    - Other Advanced 1990-2001: 0.41
    - Other Advanced 2002-2014 less 09: 0.52
    - Difference: 0.11
  - Aggregate Supply:
    - EMU 1990-2001: 0.48
    - EMU 2002-2014 less 09: 0.63
    - Difference: 0.15
    - US regions 1990-2001: 0.68
    - US regions 2002-2014 less 09: 0.59
    - Difference: -0.09
    - Other Advanced 1990-2001: 0.41
    - Other Advanced 2002-2014 less 09: 0.40
    - Difference: -0.01
- Further experiments:
  - Including non-euro European countries (UK, Sweden, Denmark): these form part of the European periphery with supply-shock correlations similar to France, Belgium, Austria, and Finland; two of these countries show negative correlations of aggregate demand shocks with Germany (one is Denmark, which pegs to the Euro).
  - Direct test of financial accelerator impact (exact correlation values preserved):
    - GIIPS: With Financial Accelerator 0.42; Without Financial Accelerator 0.12; Difference 0.30
    - Other Euro Area: With Financial Accelerator 0.34; Without Financial Accelerator 0.32; Difference 0.01
    - Other EU: With Financial Accelerator 0.23; Without Financial Accelerator 0.21; Difference 0.02

### IV. Conclusion — synthesis and policy implications
- Summary conclusions:
  - Correlation of shocks remains higher in the U.S. than the Euro Area; Europe remains further from satisfying symmetry-of-disturbances criterion for an optimum currency area.
  - A Euro Area core and periphery persist, but the recent core includes the crisis countries (GIIPS) as those with the highest correlations with Germany.
  - Increased correlation between Germany and the GIIPS reflects a financial cycle and procyclical banking behavior rather than deeper structural convergence toward an optimum currency area.
  - Post-euro impulse responses deviate from textbook AS/AD expectations: prices rise in response to permanent (“supply”) shocks in the Euro Area, consistent with hysteresis via financial amplification.
- Policy implications and warnings:
  - Stabilizing the Euro Area requires more vigorous, coordinated regulation of the European banking and financial system.
  - Progress noted: creation of a Single Supervisor and a common resolution mechanism.
  - Remaining gaps and concerns:
    - Single Supervisor has yet to be battle tested.
    - Common resolution mechanism feasibility is open to question.
    - Banking union lacks a common deposit insurance scheme with a fully funded financial backstop.
    - Regulators continue to rely on banks’ own internal models for capital adequacy — a practice that risks persistent lending booms and busts.
- Final judgment:
  - Unless regulatory frameworks change (notably reducing reliance on banks’ internal models), the Euro Area will remain prone to financial booms and busts with destabilizing macroeconomic consequences.

*Source: wp1755 - 1. U.S. Adjustment AS/AD (wp1755.pdf)*

### 1. U.S. Adjustment AS/AD ____________________________________________________8

### 1. U.S. Adjustment AS/AD

### Major sections and themes
- 1. U.S. Adjustment AS/AD ____________________________________________________8
- 2. U.S. Impulse Responses ___________________________________________________10
- 3. EA Impulse Responses ____________________________________________________11
- 4. Euro Area Adjustment: Financial Hysteresis ___________________________________13
- 5. US and Euro Area Aggregate Demand and Supply Shocks Over Time _______________16
- 6. Euro Area vs. US  ________________________________________________________17
- 7. Euro Area vs. non-Euro countries ____________________________________________20

### Tables referenced in the content unit
- TABLES
  - 1. Proportion of Variance Explained by the First Principal Component  ________________19
  - 2. Correlations of  __________________________________________________________21

### Appendices included
- APPENDICES 
  - Appendix: Impulse Response Functions for the Euro area, US Regions, and other Advanced Countries _________________________________________________________________24

*Source: wp1755 - 1. U.S. Adjustment AS/AD (wp1755.pdf)*

### References  _______________________________________________________________23

### References  _______________________________________________________________23

### I. INTRODUCTION
- Historical context and motivation:
  - 1990s consensus: neither Europe nor the United States was an optimum currency area.
  - Previous finding (Bayoumi and Eichengreen (1993)) documented larger dispersion of shocks in Europe than the United States.
- Approach and scope:
  - Revisit earlier issues after 25 years using distinction between temporary and permanent disturbances to output (interpreted as aggregate demand and supply shocks).
  - Data span and sample: VARs estimated with two lags; estimation period is 1990-2014 (25 years of data).
- Key findings and surprising results:
  - The United States continues to resemble an optimum currency area more closely than the Euro Area under the symmetry-of-disturbances criterion.
  - A Euro Area core–periphery distinction persists, but the post-euro core (highly correlated with Germany) now includes Portugal, Ireland, Italy, Spain, and Greece (the GIIPS), contrary to earlier periods where Northern neighbors comprised the core.
  - Price responses differ across jurisdictions:
    - United States: temporary positive shocks to output raise prices permanently; permanent positive shocks reduce prices.
    - Euro Area: permanent positive shocks to output raise prices rather than lower them (contrary to textbook AS/AD model).
- Interpretation:
  - Financial-hysteresis mechanism: aggregate supply and demand shocks become endogenously linked via financial markets (financial accelerator).
    - Positive supply shocks → higher asset prices → increased bank capital and lending → higher investment and demand → further output increases and higher prices.
    - Negative demand shocks → lower asset prices → reduced lending → amplified declines in demand and output, leading to deflation.
  - Institutional/regulatory drivers:
    - Euro Area banks: greater reliance on banks’ internal models and Basel risk weights; intensified bank competition and elimination of exchange risk after the euro increased elasticity of bank lending.
    - U.S. banks: constrained by a U.S.-specific “simple leverage ratio” (required commercial banks to hold at least 5 cents of capital for every dollar of assets), limiting the financial accelerator.
- Policy implication highlighted:
  - Need for vigorous, coordinated regulation of banking and financial systems by a single supervisor; monetary union without banking union will not work.

### II. ESTIMATION RESULTS
- Data and methodology:
  - Variables: growth and inflation are first differences of the logarithm of real GDP and the GDP deflator.
  - Blanchard-Quah decomposition used to separate permanent (aggregate supply) and temporary (aggregate demand) shocks.
  - Countries/regions: eleven initial Euro area members and Euro area as a whole; eight U.S. BEA regions; ten additional advanced countries.
  - Sample choices: estimation period 1990-2014; main correlations start calculations from 1994; exclude 2009 from correlation analysis.
- U.S. impulse-response results:
  - Impulse responses conform to textbook AS/AD predictions:
    - Aggregate supply shock: gradual rise in output and fall in prices (downward-sloping AS in price-output space).
    - Aggregate demand shock: initial rise in output and prices followed by reversion of output with continuing higher prices.
  - Regional patterns consistent with expectations (e.g., mineral-rich Southwest and Rocky Mountain regions have relatively flat aggregate supply curves).
- Euro Area impulse-response results:
  - Nonstandard responses for majority of EA members:
    - One shock raises output and lowers prices but is the temporary (aggregate demand) shock.
    - The other (permanent) shock raises output and produces little initial price change followed by gradual price increases.
  - Seven of 11 long-term EA members, including Germany, display the unconventional pattern; France, Belgium, Austria, and Finland conform to the traditional pattern.
  - Ten other advanced economies mostly conform to the traditional pattern; Japan is an exception, resembling EA unconventional dynamics.
- Financial-hysteresis mechanism formalized:
  - Anticipated positive supply shock shifts AS rightward; higher asset prices and financial accelerator shift AD rightward (AS+D panel).
  - Financial accelerator operates through bank capital effects and lenders’ internal models (higher asset prices reduce perceived risk and required buffers).
  - Reverse dynamics explain deepened declines and deflation when financial disruption occurs.
- Experiments controlling for financial conditions:
  - Added contemporaneous and first lag of change in real credit, real equity prices, and real house prices as exogenous variables in the VAR to approximate removing the financial accelerator.
  - Result: financial accelerator is a major amplifier of macro shocks, especially for the GIIPS.
    - For a typical country the long-term impact on output of an “aggregate supply” shock is twice as large when financial channel operates.
    - For the GIIPS the effect is thrice as large when the financial channel operates.
  - Removing the financial accelerator causes the high correlation of “aggregate supply” shocks between the GIIPS and Germany to fall dramatically, while correlations for other EU countries are essentially unchanged.

### III. CORRELATION RESULTS
- Anchor regions:
  - U.S. anchor: the Mideast (mid-Eastern Seaboard).
  - Euro Area anchor: Germany.
- Sample adjustments for correlation analysis:
  - Start calculations using shocks from 1994 rather than 1990 (post-ERM crises and clearer run-up to EMU).
  - Exclude 2009 because it is characterized by an exceptionally large and highly correlated global shock.
- U.S. correlation structure:
  - Inner/outer structure persists; inner (highly correlated with Mideast) includes New England, Great Lakes, Southeast, and Far West.
  - Periphery includes Rocky Mountains, Southwest, and Plains.
  - Main change since earlier work: Southeast joined inner core; Plains moved to periphery.
- Euro Area correlation structure:
  - Lower correlations and less well-defined subgroups than U.S.
  - Periphery (high correlation with Germany, counterintuitively) comprises the GIIPS (Italy, Portugal, Spain, Ireland, Greece), with Greece showing relatively high correlation of “aggregate demand” shocks.
  - Netherlands and Austria exhibit high correlations of “aggregate supply” shocks with Germany; France, Belgium, and Finland are in the outer circle (low correlations).
- Principal component coherence over time (Table 1 exact values preserved):
  - Aggregate Demand (proportion of variance explained by first principal component):
    - EMU 1990-2001: 0.31
    - EMU 2002-2014 less 09: 0.29
    - Difference: -0.02
    - US regions 1990-2001: 0.75
    - US regions 2002-2014 less 09: 0.60
    - Difference: -0.15
    - Other Advanced 1990-2001: 0.41
    - Other Advanced 2002-2014 less 09: 0.52
    - Difference: 0.11
  - Aggregate Supply (proportion of variance explained by first principal component):
    - EMU 1990-2001: 0.48
    - EMU 2002-2014 less 09: 0.63
    - Difference: 0.15
    - US regions 1990-2001: 0.68
    - US regions 2002-2014 less 09: 0.59
    - Difference: -0.09
    - Other Advanced 1990-2001: 0.41
    - Other Advanced 2002-2014 less 09: 0.40
    - Difference: -0.01
- Further experiments and findings:
  - Including non-euro European countries (UK, Sweden, Denmark) in European analysis:
    - These countries form part of the European periphery with supply-shock correlations similar to France, Belgium, Austria, and Finland.
    - Two of these countries show negative correlations of aggregate demand shocks with Germany (one is Denmark, which pegs to the Euro).
  - Direct test of financial accelerator impact:
    - Adding real credit, equity, and house-price changes reduces correlations of “aggregate supply” shocks between GIIPS and Germany from 0.42 to 0.12 (difference 0.30) while correlations for Other Euro Area and Other EU change little.
    - Table 2 exact values:
      - GIIPS: With Financial Accelerator 0.42; Without Financial Accelerator 0.12; Difference 0.30
      - Other Euro Area: With Financial Accelerator 0.34; Without Financial Accelerator 0.32; Difference 0.01
      - Other EU: With Financial Accelerator 0.23; Without Financial Accelerator 0.21; Difference 0.02

### IV. CONCLUSION
- Summary of main conclusions:
  - Correlation of shocks remains higher in the U.S. than the Euro Area; Europe remains further from satisfying symmetry-of-disturbances criterion for an optimum currency area.
  - A Euro Area core and periphery persist, but the recent core includes the crisis countries (GIIPS) as those with the highest correlations with Germany.
  - The observed increased correlation between Germany and the GIIPS reflects a financial cycle and procyclical banking behavior rather than deeper structural convergence toward an optimum currency area.
  - Post-euro impulse responses deviate from textbook AS/AD expectations: prices rise in response to permanent (“supply”) shocks in the Euro Area, consistent with hysteresis via financial amplification.
- Policy implications and warnings:
  - Stabilizing the Euro Area requires more vigorous, coordinated regulation of the European banking and financial system.
  - Progress noted: creation of a Single Supervisor and a common resolution mechanism.
  - Remaining gaps and concerns:
    - Single Supervisor has yet to be battle tested.
    - Common resolution mechanism feasibility is open to question.
    - Banking union lacks a common deposit insurance scheme with a fully funded financial backstop.
    - Regulators continue to rely on banks’ own internal models for capital adequacy — a practice that risks persistent lending booms and busts.
- Final judgment:
  - Unless regulatory frameworks change (notably reducing reliance on banks’ internal models), the Euro Area will remain prone to financial booms and busts with destabilizing macroeconomic consequences.

*Source: wp1755 - References  _______________________________________________________________23*

### References

### wp1755 - References

### References
- Babecky, Jan, Philip Du Caju, Theodora Kosma, Martina Lawless, Julian Messina and Tairi Room (2010), “Downward Nominal and Real Wage Rigidity: Survey Evidence from European Firms,” Scandinavian Journal of Economics 112, pp.884-910.
- Bauer, Thomas, Holger Bonin, Lorenz Goette and Uwe Sunde (2007), “Real and Nominal Wage Rigidities and the Rate of Inflation: Evidence from West German Micro Data,” Economic Journal 117, pp.508-529.
- Bayoumi, Tamim and Barry Eichengreen (1993), “Shocking Aspects of European Monetary Unificaton,” in Francisco Torres and Francesco Giavazzi eds, Adjustment and Growth in the European Monetary Union, Cambridge: Cambridge University Press, pp.193-229.
- Bernanke, Ben S., Mark Gertler, and Simon Gilchrist (1999) “The Financial Accelerator in a Quantitative Business Cycle Framework,” in Handbook of Macroeconomics Volume 1C, editors John B. Taylor and Michael Woodford, North Holland, pp. 1341-1393.
- Blanchard, Olivier, Eugenio Cerutti and Lawrence Summers (2015), “Inflation and Activity: Two Explorations and their Implications for Monetary Policy,” IMF Working Paper 15/230 (November).
- Blanchard, Olivier and Lawrence Summers (1986), “Hysteresis and the European Unemployment Problem,” NBER Macroeconomics Annual 1, pp.15-90.
- Campos, Nauro and Corrado Machiarelli (2016), “Core and Periphery in the European Monetary Union: Bayoumi and Eichengreen 25 Years Later,” Economics Letters 147, pp.127-130.
- Kemmerling, Achim and Olivier Bruttel (2006), “’New Politics’ and German Labour Market Policy? The Implications of the Recent Hartz Reforms for the German Welfare States,” West European Politics 29, pp.90-112.
- Romer, David (2011), Advanced Macroeconomics, New York: McGraw-Hill.

### Appendix: Impulse Response Functions
- Appendix: Impulse Response Functions for the Euro area, US Regions, and other Advanced Countries
- Euro Area Countries and Euro Area
- US Regions and US
- Other Countries

*Source: wp1755 - References*

---


_Source: https://www.imf.org/-/media/files/publications/wp/2017/wp1755.pdf_