| Any policy analysis in economics must be consistent with the economic theory and the time series properties of macroeconomic data. Poor performance of real output models requires bringing more economic theory into these models. This work proposes a vector error correction model of seven economic variables in the U.S.: real GDP, GDP deflator inflation rate, nominal federal funds rate, nominal yield on 10-year government bonds, real cyclically adjusted budget balance, real potential output, and imported oil price. The vector error correction model is anchored by three long-run equilibrium relationships suggested by economic theory, including real federal funds rate, term structure, and GDP gap. Aggregate demand and supply components were found to play an important role in determining real output. |
