Identifying Supply and Demand Shocks Using Dynamic Principal Component Analysis

This chapter shows that the economy can be described by two factors: an inflationary demand factor and a deflationary supply factor. More specifically, our approach combines the use of several filtering techniques to extract business cycle fluctuations and dynamic principal components analysis (DPCA) to extract common factors. The analysis is performed on the US data (FRED-QD dataset) ranging from 1959 (Q4) to 2022 (Q3). We illustrate that the demand factor is the most important, but the relative importance of each of the two factors changes over time. In addition, we show that the factors obtained using DPCA generally correspond to the identification of supply and demand shock using revisions to expectations from Survey of Professional Forecasters.