The impact of demand and supply shocks on inflation. Evidence for the US and the Euro area

Dreger, Christian (2023): The impact of demand and supply shocks on inflation. Evidence for the US and the Euro area.

Abstract

After a long period of price stability, inflation returned to record levels in many parts of the world economy. This paper investigates the role of demand and supply shocks behind this process. Structural VAR models are specified for the US and the euro area. Shocks are identified by sign restrictions and external instruments. Demand shocks dominate in the US and can explain roughly 75 percent of the inflation experience. Supply side shocks like bottlenecks in global value chains account for the remaining 25 percent of the variance of inflation forecast errors. In the euro area, the shocks are balanced. Depending on the specification, supply shocks may even play a larger role over longer periods. Higher interest rates can tame inflation due to their adverse effects on demand. However, supply factors are beyond the control of central banks. Thus, monetary policy might become overly restrictive if the impact of the non-demand drivers is neutralized. Due to the larger weight of supply shocks in the euro area, the risk of stagflation, i.e. a longer period of high inflation and low output growth is especially high in that region. To return to the inflation target of around 2 percent, a resolution of supply side pressures is required in any case.

• Item Type: MPRA Paper
• Language: English
• Keywords: Inflation, global value chains, supply and demand shocks, external instruments
• Subjects: E - Macroeconomics and Monetary Economics > E3 - Prices, Business Fluctuations, and Cycles > E31 - Price Level ; Inflation ; Deflation; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E52 - Monetary Policy; F - International Economics > F6 - Economic Impacts of Globalization > F62 - Macroeconomic Impacts

References

Artis M, Moreno R, Ramos R, Surinach J (2007): Study on the feasibility of a tool to measure the macroeconomic impact of structural reforms, Economic Papers 272, Directorate Economic and Financial Affairs, EU Commission.

Auer R, Fisher AM (2010): The effect of low wage import competition on US inflationary pressure, Journal of Monetary Economics 57, 491-503.

Baldwin R (2006): Globalisation. The great unbundling(s), in: Globalisation challenges for Europe, Secretariat of the Economic Council, Finnish Prime Minister’s Office, Helsinki, 11-54.

Benigno G, Di Giovanni J, Groen JJ, Noble A (2022): The GSCPI: A new barometer of global supply chain pressures, Staff Paper 1017, Federal Reserve Bank of New York.

Bhutta N, Blair J, Dettling L, Moore K (2020): COVID-19, the Cares act, and families’ financial security. National Tax Journal 73: 645–72.

Bryan MF, Meyer B (2010): Are Some Prices in the CPI more forward looking than others? We think so, Federal Reserve Bank of Cleveland, Economic Commentary 2010-02.

Carriere-Swallow Y, Deb P, Furceri D, Jimenez D, Ostry JD (2022): Shipping costs and inflation, IMF Working Paper WP/22/61, Washington.

Carroll CD, Crawley E, Slacalek J, White MN (2021): Modeling the consumption response to the CARES Act, International Journal of Central Banking 17, 107-141.

Celasun O, Hansen NJ, Mineshima A, Spector M, Zhou J (2022): Supply bottlenecks: Where, why, how much, and what next? IMF Working Paper WP/22/31, Washington.

Caldara D, Herbst E (2019): Monetary policy, real activity and credit spreads: Evidence from Bayesian proxy SVARs, American Economic Journal: Macroeconomics 11, 157-192.

Cesa-Bianchi A, Sokol A (2022): Financial shocks, credit spreads, and the international credit channel, Journal of International Economics 135, 103543.

Clarida RH, Duygan-Bump B, Scotti C (2021): The COVID-19 crisis and the Federal Reserve’s policy response, Finance and Economics Discussion Series 2021-35, Board of Governors of the Federal Reserve System, US.

Coibion O, Gorodnichenko Y, Kamdar R (2018): The formation of expectations, inflation, and the Phillips curve, Journal of the Economic Literature 56, 1447-1491.

Dieppe A, Legrand R, van Roye B (2016): The BEAR toolbox, ECB Working Paper 1934, European Central Bank, Frankfurt. Domash A, Summers LH (2022): How tight are US labor markets? NBER Working Paper 29739.

Fry R, Pagan AR (2011): Sign restrictions in structural vector autoregressions: A critical review, Journal of the Economic Literature 49, 938-960.

Gertler M, Karadi P (2015): Monetary policy surprises, credit costs, and economic activity, American Economic Journal: Macroeconomics 7, 44-76.

Giannone D, Lenza M, Primiceri GE (2015): Prior selection for vector autoregressions, Review of Economics and Statistics 97, 436-451.

Gomes S (2018): Euro area structural reforms in times of a global crisis, Journal of Macroeconomics 55, 28-45.

Guerrieri L, Gust C, Lopez-Salido D (2010): International competition and inflation: A new Keynesian perspective, American Economic Journal: Macroeconomics 2, 247-280.

Hale T, Kira A, Cameron-Blake E, Tatlow H, Hallas L, Phillips T, Zhang Y (2021): Variation in government responses to COVID-19, Blavatnik School of Government Working, Oxford University. Paper 2020/032.

Havranek T, Rusnak M (2013): Transmission lags of monetary policy. A meta-analysis, International Journal of Central Banking 9, 39-75.

Herwartz H, Rohloff H, Wang S (2022): Proxy SVAR identification of monetary policy shocks. Monte Carlo evidence and insights for the US, Journal of Economic Dynamics and Control 139, 104457.

Kilian L, Nomikos N, Zhou X (2021): Container trade and the US Recovery, Federal Reserve Bank of Dallas, Working Paper 2108.

Lunsford KG (2015): identifying structural VARs with a proxy variable and a test for a weak proxy, Working Paper 1528, Federal Reserve Bank of Cleveland.

Mertens K, Ravn MO (2013): The dynamic effects of personal and corporate income tax changes in the United States, American Economic Review 103, 1212-1247.

Mountford A, Uhlig H (2009): What Are the effects of fiscal policy shocks? Journal of Applied Econometrics 24, 960–92.

Stock JH, Watson MW (1999): Forecasting inflation, Journal of Monetary Economics 44, 239-335.

Stock JH, Watson MW (2007): Why has US inflation become harder to forecast? Journal of Money, Credit and Banking 39, 3-33.

Uhlig H (2005): What are the effects of monetary policy on output? Results from an agnostic identification procedure, Journal of Monetary Economics 52, 381-419.