Decomposing Supply- and Demand-Driven Inflation

Abstract

The extent to which either supply or demand factors drive inflation has important implications for economic policy. I propose a framework to decompose inflation into supply- and demand-driven components. I generate two new data series that quantify the degree to which either demand or supply is driving inflation in a current month. The demand-driven contribution tends to decline during recessions, while the supply-driven contribution tends to follow food and energy prices. Monetary policy tightening acts to reduce the demand-driven contribution of inflation. Oil-supply shocks act to increase the supply-driven contribution, but decrease the demand-driven contribution of inflation.