RDP 2024-05: Sign Restrictions and Supply-demand Decompositions of Infation 5. Conclusion

Sign restrictions on the slopes of supply and demand curves provide an appealing avenue for identifying the contributions of supply and demand shocks to price changes because they are based on assumptions that are relatively uncontroversial. This is probably why they have been employed by researchers seeking to understand what has driven recent inflation developments. However, it is important to recognise that – on their own – these restrictions only allow us to conclude that the contributions lie within a set. In some cases, these sets may not allow us to draw unambiguous conclusions about whether price changes are mostly driven by shocks to supply or demand. In such cases, any additional assumptions that are used to select a single model or decomposition are likely to have a strong influence on assessments about which shocks are principally contributing to inflation.

While this paper focuses on estimating the contributions of supply and demand shocks to variation in prices, the discussion applies to other settings in which a bivariate system is identified using the same pattern of sign restrictions. For instance, models of search and matching in the labour market imply that equilibrium unemployment and vacancy rates are determined by the intersection of a downward-sloping Beveridge curve and an upward-sloping job creation curve (e.g. Daly et al 2012). It may therefore be appealing to use sign restrictions on the slopes of these curves to decompose variation in unemployment and vacancy rates. The analysis in this paper is useful for understanding the conditions under which such decompositions are informative.

This paper has characterised sets of decompositions, taking as given the modelling framework, which is a bivariate SVAR in prices and quantities identified via sign restrictions on the slopes of supply and demand curves. It could be useful for further work to explore what this framework identifies in terms of the underlying structure of the economy. For example, one could consider a New Keynesian model as a data-generating process and explore what the sign-restricted supply-demand framework identifies in terms of the model's underlying structural parameters and shocks.^[30]

Footnote

In a similar vein, Wolf (2020) uses the textbook New Keynesian model (as well as a quantitatively richer variant) as a laboratory to explore the ability of sign restrictions on impulse responses to identify monetary policy shocks. [30]