Sign Restrictions and Supply-Demand Decompositions of Inflation

Abstract

Sign restrictions on the slopes of supply and demand curves are often used to identify historical decompositions in structural vector autoregressions. I show that the identifying power of these restrictions depends on both reduced-form parameters and realised forecast errors. Consequently, unlike many other structural objects, the strength of identification cannot be assessed from reduced-form parameters alone. Empirically, identified sets for historical decompositions of US inflation are typically largely uninformative, both in aggregate and in most expenditure categories. Existing inflation decompositions are therefore sensitive to auxiliary assumptions used to select among observationally equivalent models.