Letters in Economic Research Updates
Monetary Policy Dilemma: Is Inflation More Sensitive to Demand Pressures or Supply Shocks in Developing Economies?
Abstract
Elwaleed Ahmed Talha
This study investigates the distinct responses of inflation to supply and demand shocks in panel of 42 developing countries, utilizing Panel Vector Autoregressive (PVAR). The analysis specifically examines the impact of domestic credit growth as a proxy for demand shocks and commodity price volatility representing supply shocks on the inflation. The findings reveal a significant asymmetry in inflation’s responsiveness. Inflation in both commodity exporters and importers demonstrates a remarkably faster and stronger reaction to supply-side disturbances stemming from global commodity price fluctuations. The inflationary peak following a commodity price shock is notably higher and occurs more rapidly, indicating an immediate and substantial pass-through effect. In contrast, the inflationary impact of demand shocks, proxied by credit growth, is comparatively more subdued and evolves at a slower pace, with a lower peak magnitude. This differential responsiveness underscores the heightened vulnerability of commodity-importing nations to external price shocks. The study highlights that while domestic monetary and fiscal policies can influence aggregate demand, their capacity to manage inflation driven by volatile international commodity prices is inherently limited. Consequently, effective inflation management in these economies necessitates a keen focus on supply-side vulnerabilities and strategies to mitigate external price pressures.