The Price-Output Correlation and the Variance of Output

Abstract

Using data from Backus and Kehoe (1992) we establish the existence of a positive relationship between the price-output correlation and the variance of output. This is consistent with the idea that reductions in the magnitude of aggregate demand shocks have been the dominant cause of changes in the price-output correlation across countries and across time. By contrast, changes in the magnitude of aggregate supply shocks would impart a negative relationship between the price-output correlation and the variance of output. We also consider and rule out the possibility that a steepening of the aggregate supply curve is the cause of the negative price-output correlation in the postwar era. In the postwar period the variance of output and the price-output correlation both fell compared to the pre-WW II period. We argue that both these changes are likely the result of a more effective monetary policy.

Keywords: Price-Output Correlation, Variance of Output, Business Cycle

JEL Classification: E00