Demand vs. Supply Decomposition of Inflation: Cross-Country Evidence with Applications

IMF Working Papers, October 17, 2023

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Title: Demand vs. Supply Decomposition of Inflation: Cross-Country Evidence with Applications
Authors: Melih Firat, Otso Hao
Publication date: October 17, 2023
Core question: What are the contributions of demand and supply factors to inflation?

Approach: Follow Shapiro (2022) to construct quarterly demand-driven and supply-driven inflation series.
Data: Sectoral Personal Consumption Expenditures (PCE) data for 32 countries.
Temporal focus: Highlight decompositions during critical periods such as the great financial crisis of 2008 and the recent inflation surge since 2021.

Decomposition results:
- Constructed quarterly demand-driven and supply-driven inflation series for 32 countries using sectoral PCE data.
- Emphasized global trends and country-specific differences across episodes including 2008 and since 2021.
Validation and responsiveness:
- Supply-driven inflation is more reactive to oil shocks and supply chain pressures.
- Demand-driven inflation displays a more pronounced response to monetary policy shocks.
Phillips curve:
- Results suggest a steeper Phillips curve when inflation is demand-driven, with implications for policy design.

External consistency:
- Supply-driven series correlate more with oil shocks and supply chain pressures.
- Demand-driven series correlate more with monetary policy shocks.
Application: Decompositions used to interpret episodes such as the great financial crisis of 2008 and the inflation surge beginning in 2021.

Policy design should account for the dominant driver of inflation:
- When inflation is supply-driven (responsive to oil and supply chain pressures), policy responses differ from when inflation is demand-driven (responsive to monetary policy shocks).
- The steeper Phillips curve under demand-driven inflation implies tighter trade-offs for stabilization policy when demand forces dominate.