An Alternative Perspective on Demand and Supply

Measuring macroeconomic demand and supply is important for a variety of reasons and is especially useful for gauging inflationary pressures. In this context, this paper departs from the standard Blanchard-Quah technique and proposes a novel identification strategy to extricate demand-supply from the business cycle. Based on insights from economy’s production structure and the sectoral output mix, it uses a Bayesian Dynamic Factor Model to obtain two factors that are found to possess relevant characteristics of demand and supply. The gap between the two is found to have a causal relationship with inflation and is a better predictor of inflation, as compared to other conventional measures of slack such as the output-gap and capacity utilisation