ofEc Responses of Final Demand and Inventories to a Monetary Policy Shock 0.0008 0.0004 0.0000 0.008 0.0016 To allow us to look at the economy's response to a monetary shock in closer detail,Figure 2 replaces log real GDP from the first VAR with two variables that sum to GDP, final demand and inventory investment, We measure both final de- mand and inventories relative to trend GDP, proxied by a six-year moving average of GDP; this normalization makes the magnitudes of the changes in the two vari- ables comparable(both can be interpreted as fractions of trend GDP)and avoid taking the log of a series(inventory investment) that is sometimes negative. note from Figure 2 that final demand drops quickly following an unanticipated tight ening of monetary policy. In contrast, inventories build up for a period of several months before beginning to decrease, implying that the fall in final demand leads the decline in aggregate production (real GDP). The fall in inventories, when occurs, appears to account for a substantial portion of the initial drop in output, which is consistent with Blinder and Maccini's (1991)evidence on the importance of inventory disinvestment in recessions. These results are summarized as Fact 2 Next, we explore what happens when we include various components of GDP in the VAR used in Figure 1. These series are added one at a time to the base VAR, M We continue to order the funds rate last, which has the effect of assuming that the Fed uses contem- us economic information, but that innovations in monetary policy do not feed back to the rest32 Journal of Economic Perspectives Figure 2 Responses of Final Demand and Inventories to a Monetary Policy Shock 0.0008 I t I I 0.0004 -0.0004 \ -0.0008 - -0.0012 0 4 8 12 16 20 24 28 32 36 40 44 48 Moniths To allow us to look at the economy's response to a monetary shock in closer detail, Figure 2 replaces log real GDP from the first VAR with two variables that sum to GDP, final demand and inventory investment. We measure both final de￾mand and inventories relative to trend GDP, proxied by a six-year moving average of GDP; this normalization makes the magnitudes of the changes in the two vari￾ables comparable (both can be interpreted as fractions of trend GDP) and avoids taking the log of a series (inventory investment) that is sometimes negative. Note from Figure 2 that final demand drops quickly following an unanticipated tight￾ening of monetary policy. In contrast, inventories build up for a period of several months before beginning to decrease, implying that the fall in final demand leads the decline in aggregate production (real GDP). The fall in inventories, when it occurs, appears to account for a substantial portion of the initial drop in output, which is consistent with Blinder and Maccini's (1991) evidence on the importance of inventory disinvestment in recessions. These results are summarized as Fact 2. Next, we explore what happens when we include various components of GDP in the VAR used in Figure 1. These series are added one at a time to the base VAR, although adding them in combinations gives very similar results. To make the mag￾nitudes of changes comparable, the GDP components are also left in levels and nor￾malized by trend GDP.8 Figure 3 shows the responses to a monetary contraction of 8We continue to order the funds rate last, which has the effect of assuming that the Fed uses contem￾poraneous economic information, but that innovations in monetary policy do not feed back to the rest of the economy until the next month (Bernanke and Blinder, 1992; Bernanke and Mihov, 1995)