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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.

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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.

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